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Plotting Your Plays on Takeover Targets

This column was originally published on RealMoney on Jan. 11 at 2:00 p.m. EST. It's being republished as a bonus for readers. For more information about subscribing to RealMoney, please click here .

Even as private-equity buyouts and corporate takeovers are occurring with increasing frequency and at record numbers, the ability to identify and profit from the next big deal remains as elusive as ever.

One of the most popular strategies is to use options, buying out-of-the-money calls on a slew of possible takeover candidates and hoping one gets a big premium bid and delivers jackpot returns. The problem is, just like the lottery itself, buying another fistful of tickets does not measurably improve your odds, but increases the likelihood of loss.

A better bet is to focus your attention, and dollars, on companies already in play, such as Harrah's (HET), or those that are courting suitors, such as Foot Locker (FL).

It might mean lower returns, but it offers a much higher probability of turning a profit. And the last time I checked, consistent hitters Cal Ripken and Tony Gwynn are heading to the Baseball Hall of Fame, while slugger Mark McGwire will be riding the pine of shame into retirement. The obvious lesson is don't swing for the fences. Be patient and wait for a situation that offers not only a reasonable risk/reward, but also a quantifiable edge.

Collapsing Time Premiums

In options-trading (or any investing, for that matter), eliminating or accurately gauging the behavior of the price variables under a particular circumstance provides an enormous edge to controlling risk and increasing the probability of a profit.

It's crucial, and advantageous, to understand what happens to the option prices on a company once it agrees to a merger/takeover/buyout: Once a deal is agreed to, the implied volatility or time premium collapses. That is, options that are out of the money will be essentially worthless, and in-the-money options will be priced at their intrinsic value.

Remember, the bulk of an option's value stems from the right to buy or sell a stock at a set price -- the strike price -- during a given time period defined by the expiration date. Once terms of a deal are agreed upon, those variables are eliminated and so, too, is the price premium awarded to the options.

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