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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 have.

Retail investors can search pending deals for option plays that could benefit from shrinking deal spreads with limited risk. To keep things simple, deals based largely or solely in cash were chosen so that target deal prices are somewhat fixed. A survey was taken of pending all-cash deals on April 9, 2012, to see if any option plays could provide attractive ways to play each takeover:

Target

Ticker

Cash Compensation

Other Compensation

Takeover Date

Options Market

Option Play

El Paso Corp.

EP

$14.65

0.4187 KMI shares, 0.64 $40 KMI Warrant

6/30/2012

Yes

Married Put

Venoco, Inc.

VQ

$12.50

None

6/30/2012

Yes

Married Put

AboveNet, Inc.

ABVT

$84.00

None

12/31/2012

Yes

No - no return

Goodrich Corp.

GR

$127.50

None

6/30/2012

Yes

No - no return

LoopNet, Inc.

LOOP

$16.50

$16.50 in cash and 0.03702 shares of CoStar Group

4/30/2012

Yes

No - no return

Motorola Mobility Holdings, Inc.

MMI

$40.00

None

6/30/2012

Yes

No - no return

Pacific Capital Bancorp

PCBC

$46.00

None

12/31/2012

Yes

No - no return

Radvision Ltd.

RVSN

$11.85

None

12/31/2012

Yes

No - no return

Solutia Inc.

SOA

$22.00

0.12 shares of Eastman common shares

6/30/2012

Yes

No - no return

China Advanced Construction Materials

CADC

$2.65

None

6/30/2012

No options

No - no option play

Convio, Inc.

CNVO

$16.00

None

4/15/2012

No options

No - no option play

Encore Bancshares, Inc.

EBTX

$20.62

None

12/31/2012

No options

No - no option play

North Central Bancshares Inc.

FFFD

$30.58

None

8/31/2012

No options

No - no option play

China GrenTech Corp. Ltd.

GRRF

$3.15

None

6/30/2012

No options

No - no option play

Harleysville Group Inc.

HGIC

$60.00

None

6/30/2012

No options

No - no option play

Southern Community Financial Corp.

SCMF

$2.88

None

6/30/2012

No options

No - no option play

SureWest Communications

SURW

$23.00

None

6/30/2012

No options

No - no option play

Of the acquisition targets with options markets, most have deal spreads that are too narrow for option plays. For example, the call market for Pacific Capital Bancorp is too rich to suggest a long call strategy. Though shares of PCBC are trading at $ 45.49, less than the takeover value of $46.00/share, option premiums would have to decline for a recommendable option strategy to surface.

There is a limited-risk play, which utilizes the takeover of Venoco, Inc. (NYSE:VQ). Contingent on takeover, Venoco shareholders will receive $12.50. An attractive married put position can be constructed by buying a VQ share at $10.97 while simultaneously buying a September put with a $7.50 strike price for $0.40 This position would risk $3.87 while affording a max profit of $1.13. This would be a maximum return of 29.2% on risk capital.

The proposed takeover of El Paso Corporation by Kinder Morgan is another opportunity for an option play. EP shares closed at $30.25 per share on Friday March 9, well below their value based on acquisition terms. Upon acquisition, EP shareholders will receive $14.65 in cash, 0.4187 in KMI shares, and 0.640 of a 5-year KMI warrant with a $40 strike price. Based on the $ 39.38 closing price for KMI shares the stock portion of payment is worth $16.89. Market values for call options can be used to inform the value estimate of the promised warrant. January 2014 calls on KMI shares with a $40 strike most recently traded at $1.80 and have a bid of $1.20. These warrants are worth more than these KMI calls because they have a longer expiration date, and because the threat of dilution from the EP acquisition and warrant exercise should already be priced in to KMI shares. Based on a mid-range $1.50 estimate for warrant value, 0.640 of a warrant is worth $0.96. Adding the cash, stock, and warrant value gives a $32.10 deal value per EP share. Investors can try to capture the deal spread by buying EP shares and simultaneously purchasing an EP July put with a $28.00 strike price for $1.19. Investors would risk a $3.44 maximum loss for a gain of $0.66, a 19.2% return on risk capital based on current market prices. This position is particularly attractive because it has no ceiling.

Notice that plays like these are not the norm. Most of the target firms lack a liquid options market or have deal spreads that are too narrow to compensate investors for option 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.

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

Disclaimer: Please read the article disclaimer here.

Source: April's Merger Arbitrage Option Plays