How do I buy options to make a huge windfall profit when a company gets taken over? This question is typically asked by someone who heard from a friend who heard from another friend that a publicly traded company is a merger / acquisition target.
The people asking usually do not let onto the fact that they think they have insider information. Let me just say this; If after you read this article you buy options and then make a million dollars, you can be sure the F.B.I. and S.E.C. will come knocking on your door pretty soon!
The details of the trade:
The public company is currently trading at $20 a share. The rumor is that they will be bought or merged at a price of $30 a share. So the simple thought is to buy the $25 call for a nickel, and them boom make 100 times your money.
Here are the problems with trading takeover announcement:
When is the deal going to be announced? If the deal is announced in 3 months time the speculator needs to buy options that expire in more than 3 months. Which strike price do you buy? The $22.50, $25.00 or the $30. Buying the $30 call is useless and I will explain why.
A deal can be either all cash, cash & stock or all stock. If the deal is all cash, which are the best deals, it may be subject to financing or regulatory approval. If the all cash deal is announced on June 1st for $30 a share and they say the deal will close on Dec 31st, the stock price will rise to $29, not $30 because there is a merger arbitrage discount that factor in the risk of the deal falling apart.
If the deal is cash & stock, the stock rise but the portion that is in stock will cause the stock price of the acquirer to fall and again, the stock will not rise to the full $30 unless but the cash component and the stock component add up to $30. Theoretically, if the acquirers stock rises, the deal can be worth more than $30 a share.
When you are dealing with options, you must remember the “time value”. Options are constantly losing value because they are closer to expiration. So as we mentioned earlier, you must buy a call option that expires after the deal announcement.
Sometimes the rumor says the announcement will come in June but only comes in August and your July options are now worthless. Thinking about using weekly options? You better be best friends with the investment banker and know 100% that this insider information is worth it!
Option markets very far out of the money are not liquid. Meaning, say you wanted to buy that $25 call, on a stock that has had no indications that it is a takeover target, there will be no big and the ask price will be $0.15. And there will probably only be 45 calls for sale at that price. If you try to buy $5000 worth of call options (333 calls) the order will not get filled and will also raise a red flag on why the hell would someone BUY a 333 call that far out unless they think there is a reason for the stock to bounce 20% in such a short span.
Have a look at the chart for Best Buy which is open knowledge to everyone that there is an effort by the former CEO and minority shareholder to take the company public. See that pop and drop in mid December? It is called, deal on deal off in a matter of 24 hours.
Read more about covered calls, or as we like to call it, go for singles not home runs!
Also, have a look at the beginners guide to trading options. You may learn a thing or two!