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Options Forum: Managing Mandalay

Steve:

I read your article on MBG options. How would you benefit from the price difference between the '05 and '06 expiration dates? Would you buy one and sell the other?

-- J.C.

The reader is referring to a recent article in which I suggested there might be an opportunity for a small arbitrage position in Mandalay Bay (MBG) options in the wake of the proposed takeover by MGM Mirage (MGG).

The suggested strategy was to buy the Mandalay Bay $65 calls, which expire in January 2005, while simultaneously selling an equal number of Mandalay Bay $65 calls, which expire in January 2006. The theory is that with MGM making a bid of $71 a share, they should each have an equal potential maximum value of $6 a contract.

When I wrote that Monday column, Mandalay Bay was trading at $68.10, and January $65 calls expiring in 2005 were $4.10 and the January $65 calls expiring in 2006 were offered at $5.30, for a $1.20 spread between the two. As I wrote, "the price discount and potential arbitrage between the 2005 and 2006 calls is an indication of the odds that the deal will not be approved and closed before January 2005."

But the theory behind the suggestion was that as time moves forward, it will bring into clearer focus how the deal will play out. If there are no major roadblocks to completion, you'd expect shares of Mandalay to creep higher toward the $71 takeout price; therefore the spread between the two calls would narrow in the coming months.

On Friday, with Mandalay now at $68.32, the January 2005 call is trading at $4.80 and the January 2006 call is at $5.90. So, even over the last few days (MBG didn't "officially" accept the MGM bid until Tuesday), the spread has narrowed slightly as some of this arbitrage trading may be beginning to take place.

This price action, in which the shorter-term option's value actually increases relative to an option with the same strike but with a much longer expiration date, is, of course, completely the opposite of the normal price behavior you'd expect from a calendar spread; this is because of the price cap placed on Mandalay's shares by agreeing to the $71-a-share offer. Once the deal was accepted at that price, the value for all calls with a strike above $71 became essentially worthless and the implied volatilities for all MBG options, even those that are in-the-money, crashed from the level of 40 they were sporting before MGM Mirage's bid, to below 10. Currently, both $65 calls for the January 2005 and January 2006 expirations have implied volatilities of just 10 and 7, respectively.

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