How to Play Software Mergers Using Options

by: SA Eli Hoffmann

Excerpt from our One Page Barron's Summary (receive it weekly by email by signing up here):

The Software Season by Kopin Tan

  • Highlighted companies: Software HOLDRS Trust ETF (NYSE:SWH), NASDAQ 100 Trust Shares ETF (QQQQ), McAfee Inc. (MFE), Adobe Systems Inc. (NASDAQ:ADBE), BEA Systems Inc. (BEAS), Inc. (NYSE:CRM), Cognos Inc. (COGN), Check Point Software Technologies Ltd. (NASDAQ:CHKP)
  • Summary: The Software HOLDRS Trust ETF (SWH) is up 6.9% since Aug. 1, compared to 5.8% for the NASDAQ 100 Trust Shares ETF (QQQQ), and 1.9% for the S&P 500 Index. Software stocks historically tend to rally toward year-end. Merger talks and their attendant speculative fervor have investors bidding up some software stocks on fears they might 'miss the boat' if they don't jump aboard early. Some potential targets: 1) McAfee Inc. (MFE): • Calls outnumber puts 3:1 • Susquehanna and Citigroup both recently tagged it as a takeover target. 2) Adobe Systems Inc. (ADBE): • flagged by Citigroup due to favorable rating • liquid and reasonably priced options. 3) Other companies flagged: • BEA Systems Inc. (BEAS) • Inc. (CRM) • Cognos Inc. (COGN) • Check Point Software Technologies Ltd. (CHKP). Strategy: Playing the takeover is a low-probability high-payoff move, and should only be done with options. Citigroup suggests selling long-term out-of-the-money calls, and using the proceed to buy short-term at-the-money calls. The exact time-frame of the buys and sells depends on when you're betting the merger might take place.
  • Quick comment: In last week's Barron's, J. Kyle Rosen makes a convincing case that with volatility severely underpriced, there's never been a better time to make your favorite options play. Of course, your outcome isn't guaranteed, and it's always good to remember there are some pretty shrewd investors taking the other side of your trade, but the options game is all about risk vs. reward, and in this regard, there's no time like the present. Phil Davis, Seeking Alpha's Options Trader, posts his options plays twice daily, once before the markets open, and again after they close. Shlomi Cohen has an in-depth study of the Check Point merger play.