Using Options to Trade M&A Activity

Calendar spreads allow investors to bet on merger and acquisition activity with less risk than buying call options outright, says Steve Smith of Minyanville.com, and here he offers a case study in Pandora.

Legendary value investor Mario Gabelli often describes merger and acquisition activity as "corporate lovemaking" in which the union of two produces the value of three or more through cost-cutting, synergies, or a simple gain of market share.

Companies are armed with huge cash hoards and additional currency in the form of shares at all-time highs, and they are looking amorous.

Large corporations are reluctant to spend on capital expenditures, often complaining about a "lack of visibility" in terms of demand, monetary policy, and government regulations.

But at this point in the recovery cycle, there is a real need to start to show revenue growth rather than simple earnings-per-share growth engineered by layoffs and buybacks.

The recent spate of deal activity—which includes Comcast's (CMCSA) bid for Time Warner (TWC), the combination of RF Micro Devices (RFMD) and TriQuint (TQNT), and of course, the $19 billion marriage of Facebook (FB) and WhatsApp—suggests that companies are finally feeling confident enough, or fearful enough, to press forward.

We can use options to profit from a resurgent M&A market.

But trying to capitalize on the trend with the simple buying of call options is like throwing darts. You may hit a bull's eye now and again, but odds are you're going to miss.

So let's look how options can be used to take a more conservative approach to capture value in deal scenarios.

Selling the Calendar Spread
This is an atypical use of a calendar spread:

• A calendar spread consists of buying and selling calls (or puts) with different expiration dates.

• If the near-term option is sold and the longer-dated option purchased usually for a debit, this is considered being long the spread. It is usually employed on the expectation of a gradual move higher (in the case of calls) or lower (in the case of puts) in the stock price. The sale of the near-term option helps finance the cost of the longer-dated option.

• A diagonal calendar spread refers to using two different strike prices to gain a more directional bias. Typically, this would involve buying a longer-dated, closer-to-the-money option and selling the near-term, further-out-of-the-money option. This approach costs money, or is done for a debit, and its profitability is dependent on clearing that cost basis.

For a potential takeover play, we are going to turn these typical approaches on their head. We will buy a lower-strike call and sell a longer-dated, higher-strike call.

This strategy will be done for a credit and will lead to profit if a takeover is reached, regardless of the price.

The reasoning is that once a deal is announced and agreed upon, all options will approach their intrinsic values. All options across all expirations will drop in implied volatility, essentially losing their time premiums.

NEXT PAGE: A Case Study

So the time premium of the longer-dated calls will evaporate since the upside potential of the stock has been eliminated.

Let's look at an example that properly illustrates the math.

Pandora in Play
Pandora (P) is by no means a value name, but I think it has a good chance of being a takeover candidate in the coming months.

The online-music business is growing rapidly with names like Spotify, Sirius XM (SIRI), and of course, with Apple (AAPL) in the mix.

iTunes is registering high double-digit growth and penetration rates, and Apple's new CarPlay in-car software system will expand its reach.

I think that Pandora, with its relatively low $7 billion market capitalization, has a good chance of either being combined with a competitor or simply taken over by a larger media company or even a tech giant like Amazon (AMZN).

The way I'm playing this is to buy June calls, and sell a higher strike of the January 2015 LEAPS. By selling a diagonal calendar spread for a credit, one can take advantage of a takeover or merger without having to predict the exact price or timing.

Here is the trade I have in mind:

• Buy one June $43 call for $3.30


• Sell one January $50 call for $4.50


• This equals a $1.20 net credit.

Let's break down why I think the position is attractive and how it might work.

The current delta is +0.2, or the equivalent of being long just 20 shares; if the stock moves higher and the spread moves into the money, it will gain in value. As the stock price increases so will the delta due to the fact that it is long a closer-to-the-money strike. Likewise, if the stock price declines, losses will be limited as the delta will diminish as shares fall.

Current theta, or time decay, is -0.02, or the loss of $2 a day.

This means only moderate gains or losses if the stock meanders within 5-10% over the next three months.

But what we are really playing for here is a solid bid or merger for Pandora by mid May. The maximum profit of $8.20 would be realized on a takeover above the $50 level. At that point, all options would quickly move toward intrinsic value, meaning you would capture the $7 between the $43 and $50, plus the $1.20 net credit received for the calendar spread.

On a takeover below $43, the $1.20 in premium collected would constitute the profit—small, but not bad for what would be considered a disappointing valuation of Pandora.

In terms of risks, if there is no takeover bid within the next few months, then the negative theta of June calls will begin to accelerate, causing the spread to lose value. For this reason I would close the position by mid May.

Or, there could be a bid that is hostile or facing regulatory scrutiny. In that case, the closing date and ultimate price would still be variable, so the short January calls would retain premium, widening the spread.

By Steve Smith, Contributor, Minyanville