Traders Placing Their Chips On “Deal” Names

by Dan March 31, 2011 7:49 am • Commentary

[private][private]Yesterday in my post “Let’s Make A Deal: BinShopping Edition” I suggested one way to play for a potential take-out in the often rumored AKAM would be to establish a position called a Call Spread Risk Reversal, where you sell a downside put to finance the purchase of a call spread.  This structure makes sense for a lot of reasons in names like AKAM (that are often rumored) where implied volatility in the name is likely to remain elevated as a result of such rumors.  The structure leaves you a net seller of options, so if a deal actually happens, and depending if it is all or mostly cash, a good deal of the extrinsic value should come out of the options and you will help realize a greater amount of the width of the spread prior to expiration. (Once a sales price is known, option premium only represents the chance of of a change in deal price, or deal falling through. Once the deal goes through, the options cease to exist)

-Additionally you are effectively drawing a line in the sand and stating that you are willing to buy the stock on expiration of the structure at 2 different levels, one higher and one lower, and for that risk you are taking on the downside you will participate on the upside quicker. But you have also defined the level in which you will stop participating on the upside as you have capped your gains with the selling of the further strike call that you sell against the lower strike call that you own completing the call spread.

THE TRADE:

Yesterday, a decent size Call Spread Risk Reversal traded in RSH, which not only has been a rumored take-out candidate for years, but the company actually at one point made their desire to explore strategic alternatives public (read here).

-The specific trade (stock ref ~15.34) was a sale of 5k of the Jan12 12.50 puts at .90, a purchase of 5k of the Jan12 15 calls for 2.15 and sale of 5k of the Jan12 22.50 calls at .25. So the spread resulted in a net debit of 1.00.

-Break-evens on Jan12 expiration are as follows:

Upside: btwn 16 and 22.50 can make up to 6.50, btwn 15 and 16 lose up to 1.00

Downside: 15 or lower lose 1.00 premium paid for structure and 12.50 or lower you are put the stock.

MY VIEW: this is a classic hedge fund take-out trade, where the buyer of the structure is looking to minimize the amount of premium outlay while defining levels in which he is willing to buy the stock…..I can’t speak to the fundamentals of RSH, only that if BBY is having problems then RSH must be in a world of hurt because that is one of the worst retail experiences in America. I can’t imagine that a U.S. retailer who has better brand value than RSH would be interested in buying them and crapping on their own brand…….So I guess if this is going to happen it will be left to the private equity geniuses to squeeze out what they can from this pig.

-also remember while this looks like a very large bet, for a hedge fund that manages hundreds of millions, or billions of dollars, this is not that large of a bet as the premium is equal to $500,000. and the worst case the buyer would be obligated to buy 500k shares of stock at $12.50 on Jan12 expiration which would be equal to $6,250,000 plus the loss of $500k in premium.

-this trade could have also been a way for a hedge fund to lever up an existing position without actually purchasing anymore stock.[/private][/private]