OPTIONS

Contributor Steve Smith of Minyanville highlights some option strategies for special situations.

In today’s piece, we’re going to look at what are generally called "special situations," or events, both known and unknown, that can have a large impact on a stock’s price, and how we can use options to predict and ultimately profit from the outcome. I want to look at three areas—mergers and acquisitions, earnings reports, and extreme moves. The first two categories would fall under predictive plays—that is, you take action before an expected event. The third would be considered reactive in that you respond after the fact.

Mergers and Acquisitions
Mergers, both real and rumored, may be coming back in vogue, providing not only a catalyst for stock-price movement, but for an increase in option activity. While overall M&A volume is near three-year lows, there are signs that with healthy balance sheets, low interest rates, and a slowly returning sense of confidence, we might expect a dramatic pickup in activity in the near future.

According to PricewaterhouseCoopers, as of the beginning of 2012, US corporate balance sheets had over $1.4 trillion in free cash, while private equity firms held in excess of $1 trillion in uncommitted capital. Last year, we saw a string of strategic corporate mergers, especially in technology, as firms like Intel (NASDAQ:INTC), Hewlett-Packard (NYSE:HPQ), and Amazon (NASDAQ:AMZN) gobbled up young companies for huge premiums, handing out big profits for those that found themselves sitting on out-of-the-money calls. These land grabs are hard to predict and, Facebook-for-Instagram notwithstanding, unplayable anyway, and they have somewhat subsided of late.

Instead, we are seeing more synergistic acquisitions, like Roche's (PINK:RHHBY) play for Ilumina (NASDAQ:ILMN), Energy Transfer Partners’ (NYSE:ETP) bid for Sunoco (NYSE:SUN), and Coty’s offer for Avon (NYSE:AVP). In deals like these, companies look to mix and match parts to fill in product lines and/or boost top-line revenue as organic growth stalls.

While these types of transactions may continue, I think the best money-making opportunities overall will come in the reemergence of private equity and activist investor hedge funds making deals to take companies private.  A great example of this was the purchase of PF Chang (NASDAQ:PFCB) by Centerbridge Partners for $1.1 billion, or a 30% premium to the prior day’s close.

NEXT PAGE: Identifying What’s in Play

Tickers Mentioned: Tickers: INTC, HPQ, AMZN, SUN, AVP