Hi, it's Scott Bauer. I am thrilled to be associated with Trading Advantage, one of the largest schools for traders in the world. Like Larry Levin I have made numerous appearances on the financial television networks including CNBC, Fox Business and Bloomberg. Even though I appear on TV, like all of you, I am inundated with a never-ending barrage of financial information. I recognize that there are times when stocks, and specifically stock options prices, will be affected by this overwhelming "hype". Often this hype comes when a stock is rumored to be a potential buyout target. I have developed The Takeover Signal Strategy, a limited risk approach to capture the volatility aberration in stock options prices that can occur from the initial media hype of a rumored takeover. Scott has 20+ years of professional equity and index options experience including more than a decade as a Chicago Board Options Exchange market maker and as a trader for Goldman Sachs. Scott graduated from the University of Illinois Business School and has taught classes both at his alma mater and at the CBOE.
When a stock is rumored to be in play, whether it's a struggling company being gobbled up by a competitor or a high-flying upstart that may be acquired by an industry leader, both the stock's price and the stock option's prices will often be affected. While the news reports may be telling us that the takeover is imminent, this may often not be the case. Still, the options prices may initially reflect the expectation of an immediate takeover. The Takeover Signal is designed to capture the volatility blip that comes during the initial hype period. The implied volatility of the longer term options will often be much lower than the shorter term or front month options, because the expectation will be that once the takeover happens, the stock will move in a narrow trading range. However, as takeover talks drag on (which they often do), the volatility component of the longer term stock options will increase as the market participants recognize that the buyout talks may stall or not occur at all. Implied volatility is a gauge of anticipated future price movement of the underlying stock. It is an indicator of the current sentiment of the market, and is used to help determine whether an option is overvalued or undervalued. The company must be a buyout target to be considered, but there are other criteria I apply from my proprietary "SURVEILLANCE LIST" to make sure the signal can be considered. I need to make sure the following conditions are met: The Stock price is trading near the six-month-high OR the stock price is trading near the six-monthlow. Said another way, I am only looking for a stock where the price is trading at or near a major support or resistance level. There is significant open interest for the stock's At-The-Money Options (these are the options with strike prices closest to the stock price.) You are looking for options contracts with enough liquidity to execute orders on a relatively small bid/ask spread.
I am looking to capture the initial blip in volatility caused by the takeover rumors, but I want to put on a limited risk strategy. I teach that you don't want to outright or naked sell options, so I created the Takeover Signal Strategy as a spread. I am looking for a substantial volatility disparity between the front month options and one of the next two months. You can find the implied volatilities of individual stock options from a number of free sources including the Chicago Board Options Exchange. CBOE Link Click Here Because stock prices and implied volatility usually fall into line after time passes and the chances of an immediate takeover dwindle, I look to capture the return to a more normal volatility scenario. The premium should return to the further out month options because of the renewed expectation for future price movements in the stock. For example, if a stock is trading at $49.74 and the current month is October, the front month actively traded option's contract is November and the next contract is January. You have already established that the implied volatility for the November 50 strike is significantly higher the January 50 strike. You would then look to: Sell the November 50 call Buy the January 50 call You would only enter this signal (with your broker or online) as a spread, meaning that both sides need to be executed simultaneously. This will be a debit spread. The amount you pay to execute the signal, or the debit, plus all applicable commission costs, will be the maximum amount you could potentially lose. You are not looking to hold this spread for a long period of time, usually just until the initial hype over the takeover abates which could be as short a time frame as 5 to 10 trading days. You will potentially profit because this spread will widen as the November option that you are short will decay (or lose premium) at faster rate than the January option you are long. More important, the January option should gain in value as the implied volatility increases.(the premium should return to the further out month options because there has been no immediate resolution or decision about a takeover, therefore contributing to a climate of future uncertainty for the stock.)
Lexmark (LXK), a technology company known for its digital printing business, had been a potential takeover target back in 2006. The stock reemerged in the news and was rumored to be in play again during the 3rd quarter of 2012. LXK had fallen 43% by mid-2012 and had cut 13 percent of its workforce. With the company shedding less profitable divisions, the "hype" was that it was prepping itself for a sale, even though there was no concrete information about a takeover. In early October, the stock was trading at the low of its 6 month range down near $22. The November 23 call had an implied volatility of 58% while the January 23 call had an implied volatility of 43%. With November implied volatility trading at a substantial premium to January implied volatility, you would look for the spread to widen as premium returns to the January option as the expectation for an immediate takeover wanes. Entry for Signal: LXK: October 9, 2012 Stock = $21.75 Sell the LXK November 23 call Buy the LXK January 23 call Total Debit: $.40 After 5 days with no news about an immediate takeover, the premium returned to the January option and the spread widened. You could have closed the spread at $.70 for a profit of $.30 minus commissions.
Q: Can I sell the Takeover Signal Strategy? A: No, you should concentrate on only BUYING this spread. I teach that you should be looking for volatility blips where the implied volatility is higher in the front month. Therefore, you would be selling that month and buying the next month out, or buying the calendar spread. Q: Can I trade any options strike? A: No, you are concentrating on options that are either At-The-Money or very close to ATM because these have the most premium. Q: What are my potential profit scenarios? A: The longer term option should gain in value as the expectation for future movement in the stock price returns as the takeover talks drag on. The initial volatility blip should disappear as the premium returns to the longer term option causing the spread to widen. Even if implied volatility increases in both options, it should increase more in the longer term options because of the Vega. Vega is the amount an option's price will change with a change in implied volatility. Vega increases the further out the expiration term and decreases as expiration approaches. Q: What is a scenario where I could potentially lose money? A: A concrete takeover plan could be reported when you are in the signal. In this case, the premium may not return to the longer term option because the expectation for limited movement in the stock in the future has now been confirmed. Q: How much money could I potentially lose if I use this strategy? A; The maximum amount you could lose is the amount you paid for the spread plus commissions. You must remember to not only enter the signal as a spread order but exit the signal with a spread order too.
OPTIONS RISK DISCLOSURE As with trading other financial instruments, there are risks associated with trading options, such as economic, market or demand risks. Trading options may actually lead to losses in excess of the option premium plus transaction costs. If the purchased options expire worthless, you will suffer a total loss of your investment that will consist of the option premium plus transaction costs. You should carefully consider whether trading options is appropriate for you in light of your experience, objectives, financial resources, risk tolerance, and other relevant circumstances. This brief statement does not disclose all of the risks and other significant aspects of trading options. HYPOTHETICAL PERFORMANCE RESULTS WHERE DESIGNATED AS "HYPOTHETICAL PERFORMANCE RESULTS," THE RESULTS SHOWN ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, HYPOTHETICAL PERFORMANCE RESULTS DO NOT REPRESENT ACTUAL TRADING. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT OR TRADE WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT GENERALLY INVOLVE FINANCIAL RISK AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS THAT CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMBEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.