Constellation Energy: Merger Arbitrage with Options

Constellation Energy Group, Inc. (CEG) (27.58) supplies energy products and services to wholesale customers, and retail commercial, industrial, and governmental customers in North America with three operating segments: Merchant Energy, Regulated Electric, and Regulated Gas.

This is the company that Berkshire Hathaway (BRK.A) announced its MidAmerican Energy Company planned to acquire for $26.50 per share after Standard & Poor’s threatened a downgrade that would have required CEG to post another $3.3 billion of collateral for its trading and hedging operations.

We first suggested CEG as a “Buffett Put Sale” in IVolatility Trading Digest™ Volume 8, Issue 36, The Week That Was, dated September 22, 2008, when CEG was 26.76. We suggested selling the October 20 or the October 22 ½ puts. Since CEG closed at 24.06 on the October options expiration both put sales expired out-of-the-money and the premiums of 1.35 and 2.05 were booked as gains.

Now the French owned power company EDF is bidding almost as much for half of the company as Buffett’s MidAmerican bid for the whole thing.

MidAmerican responded by saying it will not raise its bid from the original 26.50 per share. This could be an interesting opportunity as the MidAmerican bid provides a floor price while waiting to see if the EDF bid will be accepted by CEG, and while waiting for the necessary approvals. This could take quite some time to be completed. In the meanwhile, CEG makes a good covered call candidate as it is paying a 1.91 dividend for a 6.8% yield.

With a current stock Historical Volatility of 45 and with the options implied volatilities in the 60s for an IV/HV ratio of 1.39, consider these ideas.

• Buy shares of CEG at 27.58
• Sell Jan 30 call CEYAF 1.175 IV 59.56 Delta -.3504

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 1.10 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .35 for each point change in the stock price.

Based on the prices above if the shares rise and are called at 30 on the January expiration the gain would be 3.52 or 13.3% in six weeks, or 115% annualized rate. If there are no further developments between now and January and the stock remains unchanged the call will expire and another call option could be sold for the April expiration. In that event there would be a dividend payment of .478 made in March further reducing the cost basis.

As an alternative, here is another put sale idea:

• Sell Jan 25 put CEYME 1.25 IV 60.70 Delta .3079

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 1.18 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .31 for each point change in the stock price.

Both of these suggestions have a good edge as the options are priced higher than would be indicated by the movement of the stock price alone and both have downside protection based upon MidAmerican’s 26.50 per share bid for the company.

Disclosure: no positions

Comments

[barrylerner...:]

Jack: You got hosed on this idea today. You didn't figure the instability and uncertainty that the new French deal introduced into the market. The enormous payout to MidAmerican is a thing of beauty. Nice return for the Oracle.

2008 Dec 17 04:16 PM

[barrylerner...:]

Jack: You got hosed on this idea today. You didn't figure the instability and uncertainty that the new French deal introduced into the market. The enormous payout to MidAmerican is a thing of beauty. Nice return for the Oracle.

2008 Dec 17 04:16 PM