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Friday, June 22, 2007

Buy Options On M&A Rumours? Becareful!

Floor talk: Taking a look at call buying in stocks with M&A rumors

It has become a regular observation to see increased call buying coincide with M&A rumors as of late, as the purchase of a call option can offer a leveraged "bet" on an upside move in a stock, with additional gains coming from the possibility for rising implied volatility. In fact, it is becoming such a widespread trend that many of the major financial media outlets have begun to regularly highlight examples of heavy options trading in reaction to M&A rumors in stocks, sometimes as a way of adding their own perceived "validity" to the rumor being discussed. While the magnitude of options activity within each individual "rumor-stock" is widely varied, the typical reaction to an M&A rumor in the options mkt involves increased near-term call buying, with a focus on the upside contracts. Buyers of these options hope to profit from the rising value of the call options, which can be the result of two potential factors (often occurring together):

1) the stock price rises as the rumor catches on in the equity mkt, causing the value of the option price to rise simply as a function of option pricing models; and

2) implied volatility rises as market-makers raise their offers to keep up with the surge in demand for these options, also leading to higher options prices.

We wanted to highlight this recent trend as our Options Activity comments often include options that are trading in stocks that are the subject of M&A rumors. We're not saying the options activity necessarily validates a rumor, but it does attract attention and there are a few examples of this type of activity today in NFLX, TSN and FCX. To look at the TSN example in more detail, we note that TSN stock saw a quick 0.60 move to the upside as a takeover rumor made the rounds. The Jul 25 calls saw the most buying in reaction to the rumor and coinciding move in the stock, with a total of 14.2K shares trading on the day. This compares to open interest of only 1440 contracts, which means before today there were only 1440 open positions in these calls. The price of these options rose to 0.45, up 350% from yesterday's closing price of 0.10, on a combination of an increase in the stock price and increased implied volatility. It's worth noting that DJ reported this afternoon that the TSN sees no basis for takeover rumors.

Source: Briefing.com

As Briefing rightly pointed out, such options activity does not necessarily validates the rumour, in other words, if you choose to buy a call option on such rumours, it is a speculative trade. If you wish to enter a speculative trade, please trade carefully and take note of the following:

-Risk only a tiny tiny portion of your capital. My own benchmark is to only risk whatever I'm prepared to lose 100%. If $500 is your threshold, which breached will cause you to lose sleep over it, then DO NOT place more than $500 on this trade

-Keep to day trading for such trades if possible

-If you hold overnight, be prepared to lose 100% of it overnight. Because if the speculated companies come out to state its stand that such rumours are groundless after market close or before market opens the next day, the stock is likely to come crashing back to earth and there is nothing you can do about it.

-If you plan to hold it for a few days, do take some profits off the table along the way and adjust your stop accordingly.


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