Using Equity Derivatives to Profit from Microsoft's Yahoo Bid

Microsoft (MSFT) came out with its long anticipated bid for Yahoo! (YHOO) earlier this month. From a strategic point of view, the deal makes sense for both Yahoo! and Microsoft. Thanks to Google’s (GOOG_) dominance in the online search space, the deal is unlikely to face anti-trust issues in the USA. Though Microsoft is still grappling with European regulators, it will not be easy for the regulators to come with up with defensible reasons to block the deal.

Yahoo! has already rejected the original bid for $31/share. However Yahoo!’s strategic options are rather limited, and the whisper is that Yahoo!’s board is angling for a better price. Microsoft has reiterated their plans to continue pursuing Yahoo! and Wall Street analysts are suggesting that Microsoft may raise its offer to the mid-30s to nudge Yahoo! along.

Yahoo! closed at $29.63 on Tuesday, up more than $10 from its closing price the day before Microsoft’s offer became public. Assuming the deal gets done in the mid 30s, Yahoo!’s stock offers an upside potential of about 20%. On the flip-side, if Microsoft withdraws its bid, Yahoo!’s stock is likely to fall into the mid to late teens, a downside potential of about 40%.

Options on Yahoo!’s common stock are another way of trading the merger. I discuss three different strategies with different risk-reward profiles.

Vertical Spreads: The January 2009 $30-$35 spread is being quoted at an Ask price of $2.06/share. Assuming that the deal closes by January 2009, your investment of $2.06 per share will result in a return of $5/share. If the deal does not close, and Yahoo! stock continues to languish your loss will be limited to your initial investment of $2.06/share.

Calendar Spreads: The January 2009 -January 2010, call spread at $30 has a Bid price of $0.60. You can short this spread (buy Jan 2009 call and sell Jan 2010 call) and will get $0.60/share. Assuming the deal is completed by January 2009, 50% (the cash part of the buyout offer) of the extra time premium of the cash portion of for the January 2010 call is yours to pocket. Further the large movement in stock price will significantly reduce the time premium of the January 2010 option.

If the deal fails to complete, initially the time premium for the January 2009 leg will decay much faster than the decay for the January 2010 leg. However, the large downward movement of the stock price will also adversely affect the time premium for the January 2010 call, giving you ample opportunity to cover the short position without a significant loss. However, unlike the Vertical Spread, your downside risk is not limited.

Note that the end results in the calendar spread depend on the exact terms of the deal. If the terms of the deal change to all cash, the entire time premium of the January 2010 option will be yours to pocket. However if the terms of the deal are changed to increase the stock exchange component, the time premium component you pocket will be smaller and will depend on the stock price movement above the $30 strike price.

Diagonal Spreads: The January 2009-January 2010, $30-$35 spread has an Ask price of $1.75/share. You will go long the January 2009 $30 option and go short the January 2010, $35 option. This has the upside potential of the Vertical spread ($3.25/share) in case of an all cash deal. But the downside risk is similar to that of the Calendar Spread. Do note that in case the cash component of the offer does not increase, the decay in the time component of the January 2010 $35 call is going to be smaller when compared to the $30 strike call used in the Calendar spread. As a result, unless the stock price increases significantly above $35, the remaining time component of the January 2010 option will decay less than the option with strike price of $30 used in the calendar spread.