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April 28, 2011

Hedging Volatility Risk in Take-Over Stocks

Say you hear a takeover rumor. A $50 stock is rumored to be taken out at $55. Looks like a nice spec trade. You go to the option chain to look for some calls to buy. But, wow! The options seem to have gotten expensive. Implied volatility is jacked. Sometimes implied volatility can make options so expensive that even if the trade goes your way the profit is just not there–but the risk is. So, what’s a trader to do?

One solution can be to buy a bull call spread instead of instead the outright call. The rationale? It’s called hedging–hedging volatility premium. Whenever you buy options, you’re getting long implied volatility. If implied volatility is expensive, the options are expensive too. And if implied volatility subsequently falls after you make the trade, those options drop in value too. So, what if you both buy and sell an option to create a spread? Let’s look at the two legs of a bull call spread

Bull Call Spread – Long Leg

A bull call spread is when a trader buys one call and sells another that has a higher strike price. Look at it as two trades. The long call would be the one you might buy if you were to spec on the take-over stock. In the case of a take over, this call likely has high implied volatility as the market scrambles to buy up calls, making it pricey.

Bull Call Spread – Short Leg

Because there is a target price in which the take-over target is expected to be bought, you only need exposure up to a certain point–the take-over price. Why not sell a call at or above the expected take-over price? You’re not giving up upside. But you are taking in (expensive) premium to hedge the (expensive) premium you’re buying with the long call leg. It’s a perfect spread.

Example

Let’s look at this in terms of absolute risk. A stock currently trading for $50 is rumored for take over at $55. News is expected within a couple of weeks.

Buy 1 Dec 50 call at $4

Sell 1 Dec 55 call at $2

Net debit $2

Max loss = $2 (That’s better than just buying the 50 calls outright)

Max gain = $3 (That’s the $5 spread minus the $2 premium)

Break even = $52 (That’s $50 strike plus $2 spread premium)

Here the max loss/max gain ratio of the spread is 2:3. The max loss/max gain ratio of the outright call would be 4:1 (Remember, you expect the stock only to rise to $55). The spread looks better so far. Let’s look at the break evens. The spread break-even is $52. The outright call’s break even is $54. Better still.

Wrap Up

With all option strategies, there are opportune times when they offer an advantage over an alternative strategy. Bull call spreads and take-over candidates are a natural fit. Traders always need to look for ways to construct the smartest position in terms of risk-reward.

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