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Individual investors hoping to capitalize on merger arbitrage* strategies can elect to buy shares in target companies. 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 companies, 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 Compensation

Other Compensation

Takeover Date

Options Market

Option Play

EP

$14.65

0.4187 KMI shares, 0.64 $40 KMI Warrant

6/30/2012

Yes

Yes - married KMI Put

MMI

$40

1/31/2011

Yes

Yes - Long Call

TIN

$32.00

3/31/2012

Yes

No - no return

GR

$127.50

6/30/2012

Yes

No - no return

HS-OLD

$55

6/30/2012

Yes

No - no return

CPX

$7

0.945 shares SPN

3/31/2012

Yes

No - no return

NETL

$50

6/30/2012

Yes

No - no return

AATI

$5.80

1/31/2012

Thinly traded

No - no return

NDN

$22

3/31/2012

Thinly traded

No - no option play

BARI

$39.55

1/1/2012

No options

No - no option play

CADC

$2.65

3/31/2012

No options

No - no option play

BFSB

$0.80

1/31/2011

No options

No - no option play

HNB

$1.35

0.099 shares BKU

3/31/2012

No options

No - no option play

PNNW

$29

2/3/2012

No options

No - no option play

HGIC

$60

1/31/2012

No options

No - no option play

Of the targets in this list, there are two attractive options plays. A low risk way to play the $40/share takeover of Motorola Mobility Holdings expected in early 2012 is achieved by purchasing a January 2012 call on with a strike price of $38.00 for $0.90. This trade is more prudent than buying the shares at $38.80 (it reduces risk capital at the cost of $0.10 per share). The value of these options could more than double as the share price approaches the takeover price. If the share price does not appreciate before expiration this position could be rolled into buying the shares outright.

El Paso Corp. is another takeover target that is the basis of an attractive, limited risk M&A play. Shares of EP are trading at $26.57, less than the takeover value of $28.12/share plus a warrant. (If the deal goes through, each share of EP will be traded for $14.65 cash and 0.4187 shares of KMI, which currently trades at $32.17, and an out-of-the-money warrant.) By buying a share of EP and buying a KMI June 2012 $25.00 put for $0.90 establishes a $25.12 minimum value position, assuming the deal goes through. Deal risk is still present in this position, but fluctuations based on KMI price movements have been tamed. Moreover, this position retains upside potential from deal spread tightening or KMI price increases.

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

* 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 take-over 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 companies 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.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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: 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 Option Plays For The New Year