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Amongst strong objections and threats of legal action from antitrust regulators and customers who believed a Google/Yahoo alliance would have too much power over on-line commerce, Google (NASDAQ:GOOG) has scrapped its Internet advertising partnership with rival Yahoo (NASDAQ:YHOO). The market has reacted by pushing Google's stock down yesterday, yet Yahoo has seen an 8%+ jump in its share price.

This is purely because the market and a number of analysts believe that Microsoft (NASDAQ:MSFT) or another company will make another run at taking over some or all of Yahoo's on-line business. Microsoft (MSFT) had offered $33 per share in May for all of Yahoo, but that offer was rejected by management and the board. With Yahoo now trading at $14 in a depressed on-line and off-line economy, Microsoft can now get a second takeover shot at a much cheaper price. If it thought Yahoo was worth $33 a few months ago, surely it would see it as a bargain at its current price.

How to play this trade

Before discussing potential ways I plan to play this takeover (like my BUD/Inbev arbitrage trade), I must warn that this is a speculative play based on the potential for a takeover and not on fundamentals. If a takeover does not materialize, then it is likely the Yahoo share price will stay flat or fall lower given its eroding on-line market share. So do your own research before jumping in.

That being said, I think Microsoft is desperate to get Yahoo's search engine and advertising platform in order to effectively compete with Google. It also has the cash to buy Yahoo without having to rely on the tight credit markets. There is also the potential for other media companies like AOL/Time Warner (NYSE:TWX) and News Corp (NASDAQ:NWS)to make a play for Yahoo at current prices. Most importantly, frustrated Yahoo shareholders (starting with activist Carl Icahn) have lost confidence in Yahoo management over past deals and so a potential suitor should easily be able to get shareholder approval. Clearly there are a number of catalysts to suggest that Yahoo's days as an independent company are running out.

You can simply play this trade by buying Yahoo shares. For example at the current price of around $15, you would need to spend $1500 to buy 100 shares. If the takeover price is at $20, then you stand to make $500. Not bad. However consider the same play with options, which can provide more exposure and profits for the same cost, albeit with more risk.

Here's the options play. Jan $15 call option contracts are currently selling for about $2. Given each contract consists of 100 shares, for $1400 you can buy 7 contracts. This gives you exposure to 700 shares, compared to 100 shares under the straight stock purchase. Assuming the take over at $20 or more materializes before the call options expire in January, then you could stand to make between $5 and $7 per option contract. This is equivalent to a gain of $2100 to $3500. Much more than just buying the shares. However, the down side with options is much worse too. If the share price stays at $15 or less at option expiry (Jan 17th) you could lose your entire investment. If you had bought the shares, you would only have lost part of your investment.

There you have it. Risk for more reward, or safety for a lower return. The choice is yours, but this is a play worth considering.

Stock position: None.

Source: A Yahoo Takeover Trade as Google Partnership Crumbles