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Trading Options on Takeover Deals

David Borun

In an effort to expand its presence into the middle-market asset management business, Morgan Stanley (MS) announced on Thursday that it would be buying online brokerage firm E-Trade Financial (ETFC) for approximately $13 billion in stock. Morgan Stanley is known as full-service manager that has previously catered to very wealthy investors and the E-Trade purchase will give it more than 5 million additional accounts and roughly $360 billion more in managed assets.

A price war in the inline brokerage industry has put pressure on revenues, but even though they’re paying low trading commissions, loyal customers still present an opportunity for profits in banking and loan services, managed products and the juicy spread between borrowing and lending rates in margin accounts.  

Brokers like E-Trade - with millions of individual customers and an average account balance of about $70,000 - now represent attractive takeover targets as bigger institutions seek to exploit economies of scale in those profitable lines of business.

In the options industry, takeovers are part of a group of events known collectively as “corporate actions” that also includes stock dividends, special cash dividends, spinoffs, splits and anything else that materially changes the nature of the underlying security.

In most instances, the Options Clearing Corporation adjusts the terms of existing options so that there’s as little financial effect as possible on the value of those contracts. For instance, if a company enacts a 2 for 1 stock split, the existing options have their strike price halved and their quantity doubled.

If you owned one call option with a strike of 100 before the stock split 2 for 1, your position would be adjusted so that you owned two calls with a strike of 50. The economic impact is zero.

In a takeover in which one company is buying all of the shares of another company for cash, options on the target company will all be settled at the purchase price on the day the deal occurs. Consequently, the value of all options goes to parity with the offer price - regardless of the original expiration date. Any remaining time value in any option is a function of doubt that the deal will occur, possibly due to a lack shareholder support, worries about regulatory approval or the chance for a rival bid.

Once the market considers it a “done deal,” the time value of options disappears entirely.

In the case of an all-stock deal like the Morgan Stanley purchase of E-Trade, once the deal closes, the existing E-Trade options will become options on Morgan Stanley shares the same ratio as the offer – in this case 104 shares of Morgan Stanley.

The current prices of both stocks suggest the markets are expecting minimal hurdles to this deal closing. That’s not surprising, given that it would be foolish for E-Trade shareholders to vote against the deal (and forgo earning a 23% premium on their share) and regulators have approved similar deals recently.

With Morgan Stanley trading at about $54/share, E-Trade shares are trading at $55.50/share. $54 times 1.0432 is $56.48, so there’s less than 1% premium left for E-Trade shares to appreciate relative to Morgan Stanley shares if the deal closes. That doesn't mean they can't go up or down, but they'll do it together, moving in near lockstep.

There are occasionally very short lived arbitrage profits available when deals like this are announced. Sometimes rounding issues mean options positions won’t be worth exactly the same after the adjustment. (The exact proposed ratio of the Morgan Stanley deal is 1.0432. The options adjustment on some strikes might be off by .32 shares.) The options markets are very efficient however, and those mispricings disappear almost instantly.

Because there are literally an infinite number of ways for a corporate action to be structured, the OCC can’t have a printed rule for every possible circumstance, so in non-standard deals, they employ a committee method for determining how options should be adjusted to best minimize the economic impact.

That that doesn’t mean you can’t make or lose money on corporate actions. Share prices definitely move in response to expected or announced deals and the options prices reflect those moves. It simply means you’re not going to make or lose huge sums based on the mechanics of what happens to the options.

In a cash, stock or combined cash/stock buyout offer, the bidding company generally pays a premium to the current share price of the company being acquired.  The implied volatilities of options on the acquiree go to somewhere between zero (in an all cash offer) and the vol on the options of the acquiror (all stock).

So the best trade you could have on before a deal is announced is to own vertical call spreads in which you own at-the-money calls and are short calls with a strike at the offer price. Your long calls will appreciate, reaching parity with the stock as the shares rise and your short calls will decline to very close to zero.

Picking out the next takeover target is certainly a difficult game, but if you’re going to give it a shot, choose a trade in which you’ll make money from the expected movement in the stock as well as in volatility for the best risk/reward ratio.

-Dave

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