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After the closing of AT&T Inc.’s (NYSE:T) acquisition of T-Mobile from Deutsche Telekom AG (OTCQX:DTEGY), many analysts and investors believe that further consolidation in the wireless sector is very likely. In fact, Oppenheimer analysts even called it “inevitable” in a research note earlier this week. So, what’s the best way to play this potential consolidation?

Using Options to Profit from Consolidation

One of the best ways to profit from consolidation is through the use of stock options. By finding the most likely takeover candidates and hedging against a broad decline, traders can isolate the opportunity in a leveraged pairs trade. Specifically, the trade will involve buying call options in two likely takeover candidates and offsetting industry declines by purchasing puts on industry ETFs.

The trade will be profitable in the event of a takeover due to both the appreciation of the takeover candidate’s stock price (and therefore call option), as well as the potential decline in the rest of the sector. This decline can be divided into the buyer’s stock – which typically takes a hit in these situations – as well as a drop in the price of other wireless stocks that were trading higher on hopes of a takeover.

Finding the Likely Takeover Candidates

The first step in constructing this trade is to find likely takeover candidates in the industry. Oppenheimer recently noted that it believes Leap Wireless International Inc. (LEAP) and MetroPCS Communications Inc. (PCS) are the two most likely candidates. With both candidates adding subscribers and having relatively low churn rates, this thesis seems to be rather on track.

Traders betting on these two companies can purchase LEAP’s 16 Jan ’12 calls for $2.36 per contract and PCS’s 16 Jan ’12 calls for $2.05 per contract. These trades can then be offset using the Merrill Lynch Wireless HOLDRs ETF (NYSEARCA:WMH) or iShares Dow Jones US Telecom ETF (NYSEARCA:IYZ). The latter has 20 Nov ’11 puts trading for around $0.90 per contract, and would require about 5 contracts per LEAP/PCS contract to offset.

Cautionary Notes and Trade Execution

While LEAP and PCS both have actively-traded options, IYZ and WMH do not have as many contracts traded, which may make them difficult to buy and sell before expiration. As a result, investors may also want to consider industry bellwethers (or a basket of them), such as Sprint Nextel Corporation (NYSE:S) or Verizon Communications Inc. (NYSE:VZ) for the put end of the trade to provide more liquidity.

Source: Profit From the 'Inevitable' Consolidation in Wireless