Watch Options to Determine Potential Takeover Targets

There has been an increasing use of options to both identify and participate in profiting from the current buyout frenzy. Most of the focus has been on looking for a surge in the volume of call activity and an increase in the implied volatility in near-term options on the belief that these are obvious signs that a company is a takeover target.

There have been many instances of these "unusual" signs in trading activity, such as occurred in First Data(FDC) and Texas Utility(TXU). But these transactions often occur too quickly and too close to the event for the average investor to take advantage of the "tell" being provided by the options market.

Some people might find solace in knowing that the activity in both of these cases was brazen and obvious enough to get the SEC off its tuchus and launch official investigations, but that retribution does little to line our pockets or buy our babies new shoes.

A more subtle way to identify takeover candidates is to use the pricing of the LEAP options as a predictive tool for which companies investors believe are buyout targets. That is, look at the implied volatility of options across the option chain over several expiration periods with an eye toward the skew. You're watching for the implied volatility of longer-dated options to be lower than the nearer-term.

For equity options, the typical or normal skew has longer-dated options awarded a higher volatility than shorter-term options. Remember the connection between time and implied volatility. This also assumes there is no known upcoming event such as an earnings report or court ruling within a specific time period. Implied volatility can be viewed as the interest rate on bonds in that the longer the duration or expiration, the greater the impact a change in yield will have on the value or price of the underlying investment product.