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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 have.

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 deals on February 5, 2012, to see if any option plays could provide attractive ways to play each takeover:

Target

Takeover Price

Takeover Date

Options Market

Option Play

VQ

$12.50

3/31/2012

Yes

Yes - Long Call

MMI

$40.00

3/31/2012

Yes

No - no return

GR

$127.50

6/30/2012

Yes

No - no return

INHX

$26.00

3/31/2012

Yes

No - no return

SNDA

$41.35

3/31/2012

Yes

No - no return

TNB

$72.00

6/30/2012

Yes

No - no return

MITI

$11.00

3/31/2012

Yes

No - no return

SFSF

$40.00

3/31/2012

Yes

No - no return

NETL

$50.00

6/30/2012

Yes

No - no return

TIN

$32.00

3/31/2012

Yes

No - no return

BCSI

$25.81

3/31/2012

Yes

No - no return

DMAN

$13.20

3/31/2012

Yes

No - no return

SONO

$54.00

3/31/2012

Yes

No - no return

PBY

$15.00

6/30/2012

Yes

No - no return

SYNO

$28.00

3/31/2012

Thinly traded

No - no return

LAVA

$7.35

3/31/2012

Thinly traded

No - no option play

CRYP

$2.54

4/30/2012

Thinly traded

No - no option play

DFG

$44.80

6/30/2012

Thinly traded

No - no option play

WINN

$9.50

4/30/2012

Thinly traded

No - no option play

CSA

$4.25

6/30/2012

Thinly traded

No - no option play

CADC

$2.65

3/31/2012

No options

No - no option play

GRRF

$3.15

6/30/2012

No options

No - no option play

BLD

$0.96

6/30/2012

No options

No - no option play

HGIC

$60.00

6/30/2012

No options

No - no option play

CNVO

$16.00

3/31/2012

No options

No - no option play

WCAA

$6.50

3/31/2012

No options

No - no option play

CV

$35.25

6/30/2012

No options

No - no option play

ADPI

$19.00

3/31/2012

No options

No - no option play

Of the targets in this list there is one attractive option play. A low risk way to play the $12.50/share takeover of VQ, Venoco, Inc., expected in 2012 is achieved by purchasing a June 2012 call on with a strike price of $10.00 for $1.80. This trade constrains risk to the price of the option, which is significantly smaller than today's $10.76 share price. The maximum return on one of these options is 38.9%, more than double the maximum return of 15.85% from buying shares.

Unfortunately the call market for Motorola Mobility Holdings is too rich to suggest a long call strategy. Though shares of MMI are trading at $38.76, less than the takeover value of $40.00/share, option premiums would have to decline for a recommendable option strategy to surface.

Notice that trades like the VQ call are not the norm. Most of the companies lack a liquid options market or are priced 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 one 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 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.

Please read the article disclaimer.

Source: February's Merger Arbitrage Option Plays