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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 June 22, 2012, to see if any option plays could provide attractive ways to play each takeover:

 

 

Symbol

Target Company

Deal

Takeover Date

Options Market

Option Play

GEOI

GeoResources

Cash + Stock

9/30/2012

Yes

Costless Collar

VQ

Venoco

Cash

7/20/2012

Yes

No - no return

TLB

The Talbots

Cash

9/30/2012

Yes

No - no return

CTFO

China TransInfo Technology

Cash

9/30/2012

Yes

No - no return

CBE

Cooper Industries plc

Cash + Stock

12/31/2012

Yes

No - no return

XG

Extorre Gold Mines Limited

Cash + Stock

12/31/2069

Yes

No - no return

SUN

Sunoco, Inc.

Cash + Stock

12/31/2012

Yes

No - no return

IBI

Interline Brands

Cash

9/30/2012

Yes

No - no return

PSS

Collective Brands

Cash

10/31/2012

Yes

No - no return

CADC

China Advanced Construction Materials

Cash

6/30/2012

No options

No - no option play

SCMF

Southern Community Financial Corp.

Cash

6/30/2012

No options

No - no option play

SURW

SureWest Communications

Cash

6/30/2012

No options

No - no option play

PSOF

Pansoft Company

Cash

9/30/2012

No options

No - no option play

CEBK

Central Bancorp Inc.

Cash

12/31/2012

No options

No - no option play

INMD

Integramed America Inc.

Cash

11/15/2012

No options

No - no option play

TIII

Tii Network Technologies, Inc.

Cash

9/30/2012

No options

No - no option play

EF

The Edelman Financial Group

Cash

9/30/2012

No options

No - no option play

NWK

Network Equipment Technologies Inc.

Cash

9/30/2012

No options

No - no option play

KCP

Kenneth Cole Productions

Cash

9/30/2012

No options

No - no option play

NEI

Network Engines, Inc

Cash

9/30/2012

No options

No - no option play

BNHN

Benihana

Cash

12/31/2012

No options

No - no option play

PLXT

PLX Technology Inc.

Cash + Stock

6/30/2012

Thinly traded

No - no return

ALTH

Allos Therapeutics

Cash

6/30/2012

Thinly traded

No - no return

Of the acquisition targets with options markets, all but one have deal spreads that are too narrow to justify option plays. For example, the call market for Talbots (TLB) is too rich to suggest a long call strategy. Though shares of PCBC are trading at $ 2.50, less than the takeover value of $2.75/share, option premiums would have to decline for a recommendable option strategy to surface.

The proposed takeover of GeoResources by Halcon Resources (HK) is an opportunity for an option play. GEOI shares closed at $37.80 per share on Friday June 22nd, well below their value based on acquisition terms. Upon acquisition, GEOI shareholders will receive $20 in cash, and 1.932 in HK shares. Based on the $ 10.75 closing price for KMI shares the stock portion of payment is worth $20.77. Adding the cash and stock gives a $40.77 deal value per GEOI share. Investors can try to capture the deal spread by buying GEOI shares while simultaneously purchasing an GEOI January 2013 put with a $30.00 strike price for $1.05 and selling a GEOI January 2013 call with a $40.00 strike price for $1.60. Investors would risk a $8.35 maximum loss for a gain of $2.75, a 32.9% return on risk capital based on current market prices.

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.

Please read the article disclaimer.

* 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.

Source: June's Merger Arbitrage Option Plays