Options Mailbag: Not All Merger Strategies Are Created Equal

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

In this week's Options Mailbag, we tackle questions regarding merger activity, and the names given to certain positions.

With the recent spate of merger activity, readers have been asking whether options can be used to profit from the price spreads between the bid and the current price.

An example is the announcement that Dow Chemical (DOW) will paying $78 share, or $15 billion in cash, for Rohm and Hass (ROH). One reader asked the following question.

Steve,

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First, you should get big royalties for looking like the thug in "Grand Theft Auto." That's a good thing! Option question that is buggin' me: So ROH gets a market top bid and goes up like crazy. Now, what would be wrong with buying ROH stock after the pop and selling 10 covered calls for July?

Thanks, JJ

Hey JJ, I'm going take that thug comment at face value. I swear I've never presented a trade to buy some calls I owned as an offer too good to refuse or imply there would be repercussions. But jokes aside, there is nothing to be gained by trying to establish a covered call, or almost any other option position.

Right now, ROH is trading around $74 a share. Assuming the $78 takeover value is achieved, that leaves $4 of upside.

The July 75 calls are trading just 10 cents today Jul. 18. So, if you sold those, you would be capping your profit to just $1.10.

All other calls over the $75 strike, which are structured in $5 increments, have no value, as it is assumed the stock will not go above $78.

Calls that are in-the-money are only trading at their intrinsic value. For example, for the $60 call across all expirations, there is no premium to collect; they all are valued at about $14 a contract.

As a friendly all-cash deal that should close in a relatively short time period, there is little, let's call it nothing, that can be done to boost gains by writing a covered call.

On the more complex deals in which stock, debt or dividends are involved, there are arbitrage situations available. An example of this would be the Inbev purchase of Anheuser-Busch (BUD) for $70 a share. BUD is currently trading around $67 a share, meaning there is theoretically $3 of profit remaining in the stock.

But this deal will take time, as I mentioned above, it involves stock, meaning that ultimately value may not be exactly $70 a share. That's why you see there is minimal value in any calls that have a strike price above the proposed takeover bid. The discount to the current stock price vs. the proposed takeover price is based on the carrying costs of owning the stock for the time period it is expected for the deal to close.

There is also some risk the deal might not go through. This is reflected in the price of the put options. Right now, an August 65 put is trading about 40 cents. This suggests a 3% chance the deal will fall apart or be done at a price below $65 a share. Not a bet I'd make at this point.

It's Calendar Spread

Can you tell me what it means to be long in say the September 30 puts and also short the August 30 puts? Does this mean you are buying the long puts or are you collecting premium by selling a naked call?

Thanks,

Thomas Boyette

If you buy a longer-dated option and sell the shorter-dated options, such as the position you describe, you are creating a long calendar spread (RedOption.com definition). This is a net debit position.

In this case, since you are using puts, it will be a bearish position. It will benefit from time decay as the near-term options sold short will experience an accelerated rate of time decay. But to be clear, you are not collecting premium.

Calendar spreads are a great way to establish low-cost directional positions that have a defined limited risk.

This was originally published on RealMoney on July 18, 2008. For more information about subscribing to RealMoney, please click here.

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