Jack Walker

A Yahoo Takeover Trade as Google Partnership Crumbles

Andy,

With option implied volatility currently very high have you considered the volatility and time decay risk of a long call option position?

For example the current implied volatility index for the Yahoo calls is 108, while the normalized forecast is between 60-70, having been as high as 140 earlier in the month.

We think there is considerable volatility risk in Yahoo that will likely remain until a final deal is reached.

If you can agree to the downside risk in the event nothing is done, that the stock could go down to 10, then a long 100 share position has about 4 points of risk, or $400.

For $433 a trader could buy 2 long Jan 15 calls YHQAC at 2.165 each, with an implied volatility of 98.19 and assume the risk of a decline in implied volatility and a loss of time decay. If a deal is done the implied volatility will decline rapidly and may approach the forecast range of 60-70 or lower. If a deal is done later in the year or early next year there will also be a loss of time premium at an increasing rate as the expiration date nears.

One way to avoid these risks is by using a bull call spread. This is done by adding a second call position by selling the Jan 17 ½ call at 1.230 each. With this combination we are now long and short January call options and we have offset most of the volatility and time decay risks associated with the long only idea.

In this example we could buy 4 Jan 50/Jan 17 ½ bull call spreads at .935 each for a total of $374. Now our maximum loss has been fixed and defined. Even if there is no deal and the stock declines to something below 10 out risk with this position is still defined and fixed at $374. In addition, if there is a collapse in implied volatility when/if a deal is announced our loss in volatility will be offset leaving us with just the price gain. What we give up for this protection is a cap on the upside. The maximum value of our spread can only rise to 2.50, the difference between the strike prices. In this example it would be $1,000 or 167% of the debit cost. Depending upon when the deal is announced this could still be a very attractive annualized rate of return, but with a now defined and limited downside risk.

Just a thought for your consideration.

Jack