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Individual investors hoping to capitalize on merger arbitrage (see note below) 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 cash deals on May 14, 2012, to see if any option plays could provide attractive ways to play each takeover:

Ticker

Target company

Cash Compensation

Other Comp.

Takeover Date

Options Market

Option Play

PBY

Pep Boys - Manny, Moe & Jack

$15.00

Delayed

Yes

Yes - Married Put

VQ

Venoco

$12.50

6/30/2012

Yes

Yes - Married Put

GEOI

GeoResources

$20.00

1.932 Shares HK

9/30/2012

Yes

No - no return

MMI

Motorola Mobility Holdings

$40.00

6/30/2012

Yes

No - no return

GR

Goodrich Corp.

$127.50

6/30/2012

Yes

No - no return

CADC

China Advanced Construction Materials Group

$2.65

6/30/2012

No Options

No - no option play

INCB

Indiana Community Bancorp

$22.95

6/30/2012

No Options

No - no option play

TUDO

Tudou Holdings Limited

$37.50

9/30/2012

No Options

No - no option play

ABVA

Alliance Bankshares Corporation

$4.77

12/31/2012

No Options

No - no option play

CEBK

Central Bancorp

$32.00

12/31/2012

No Options

No - no option play

TIII

Tii Network Technologies

$2.15

9/30/2012

No Options

No - no option play

SCMF

Southern Community Financial

$2.88

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 Motorola Mobility Holdings is too rich to suggest a long call strategy. Though shares of MMI are trading at $39.05, less than the takeover value of $40.00 per 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 Pep Boys. Contingent on takeover, Pep Boys shareholders will receive $15.00 per share. An attractive married put position can be constructed by buying a PBY share at $11.58 while simultaneously buying an October put with a $12.50 strike price for $1.90. This position would risk the $0.98 time premium of the option while affording a max profit of $1.52. This would be a maximum return of 55% on risk capital.

Another is a limited-risk play can be constructed based on the takeover of Venoco. Contingent on takeover, Venoco shareholders will receive $12.50 per share. An attractive married put position can be constructed by buying a Venoco share at $10.80 while simultaneously buying a December put with a $7.50 strike price for $0.55. This position would risk the $0.55 time premium of the option and $3.30 of VQ share price for a total $3.85 in risk capita. Max profit would be $1.15, a maximum return of 30% on risk capital.

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.

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 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.

Disclaimer: Please read the article disclaimer.

Source: May Merger Arbitrage Option Plays