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Individual investors hoping to capitalize on merger arbitrage strategies can elect to buy shares in target firms. Investing in target equity, or the “long side” of merger arbitrage, is not arbitrage in the sense of riskless return, but has historically offered alpha for investors. Not every deal will go through, but most do.

As an alternative to buying shares in target firms, individual investors could search pending deals for option plays that could capture the deal spread. To keep things simple, deals based largely or solely in cash were chosen so that target deal prices are fixed. A survey was taken of pending all-cash or part-cash deals on October 31, 2011, to see if any option plays could provide attractive ways to play each merger:

Target

Cash Payment

Non-Cash Compensation

Takeover Date

Options Market

Verdict

GR

$127.50

-

6/30/2012

Yes

Yes

MMI

$40

-

12/31/2011

Yes

Yes

HS-OLD

$55

-

6/30/2012

Yes

No - no return

ADLR

$4.25

Up to $4.50 in additional compensation for milestones

12/31/2011

Yes

No - no return

LOOP

$16.50

0.03702 Shares CSGP

12/31/2011

Thinly traded

No - no return

CPX

$7

0.945 Shares SPN

12/31/2011

Yes

No - no return

CFSG

$9

-

11/15/2011

Yes

No - no return

NETL

$50

-

6/30/2012

Yes

No - no return

MFW

$25

-

12/31/2011

Yes

No - no return

NDN

$22

-

3/31/2012

Yes

No - no return

CADC

$2.65

-

3/31/2012

No options

No - no option play

BFSB

$0.80

-

12/31/2011

No options

No - no option play

HNB

$3.54

-

12/31/2011

No options

No - no option play

FNDT

$23.33

-

12/31/2011

No options

No - no option play

PNNW

$29

-

12/31/2011

No options

No - no option play

HGIC

$60

-

1/31/2012

No options

No - no option play

CONM

$3.85

-

12/31/2011

No options

No - no option play

OCNF

$19.27

-

12/31/2011

Yes

No - deal risk, options too expensive

AATI

$5.45

Number of shares SWKS will be scaled to $5.45 Market value

12/31/2011

Thinly traded

No - deal risk

HRBN

$24

12/31/2011

Yes

No - deal risk

Of the targets in this list, only two have attractive option plays. Buying May 2012 calls on Goodrich Corp. (GR) with a strike price of $115.00 for $11.00 and selling May 2012 calls with a $125 strike price for $2.00 would create a $10 call spread for $9 that is backed by a $127/share deal price. The return on this deal would be 11.1%, and would be earned over about 8 months.

Similarly, an individual investor could purchase Jan 2012 calls with a $39 strike price on MMI for $0.65. If the deal goes through, the underlying stock would be worth $40 and the right to buy an MMI share for $39 would be worth $1. This scenario would reap a 53.8% return in two months.

Notice that these plays are not the norm. Most of the firms lack a liquid options market or are priced with deal spreads that are too narrow to pay for call premiums. In addition, two of the deals are the subject of controversy. These other deals might be tradable given the right circumstances, but not through simple option plays like those listed here.

Note: One attractive hedge fund strategy is called “merger arbitrage” or “risk arbitrage.” It involves identifying target companies that are slated to be bought out by another company, but whose prices have not quite appreciated to the takeover price. For example, if an acquiring company and a target company announced that they were striking a deal to buy the shares of the target company for $100 at a future date and the shares appreciated to $97, that $3 difference would be the deal spread that arbitrageurs would try to capture by buying shares at $97 and holding them until they were paid at $100 at the close of the deal.

Merger arbitrage can be considerably more complicated, especially when firms agree to pay for target shares with a number of acquiring company shares, or a mixture of shares and cash. Investors hoping to capitalize on the deal without any market risk would have to buy the target shares and short the acquiring shares.

Disclaimer: This article was written to provide investor information and education, and should not be construed as investment advice. I have no idea what your individual risk, time horizon, and tax circumstances are, so please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing.

Source: Merger Arbitrage Options Plays