The financial industry has been fertile ground for deals over the past year, and it still remains a hotbed of rumors about merger and takeover activity. Even if some of the buzz is totally unsubstantiated or even completely illogical, it offers abundant trading opportunities. These rumors act as catalysts for speculation, sparking price movement in both the underlying shares and the related options.
highlighted option strategies involving consolidation in the banking sector, especially among regional players. But trading on rumors is a risky endeavor because they're uncertain situations that often have unanticipated results. This risk is usually reflected by an increase in the implied volatility or valuation on the options of the companies involved.
Take Me, I'm Yours
New York Community Bank
, one of the largest savings-and-loans in the New York metropolitan area, revealed on May 10 that it had retained investment bankers to "review strategic alternatives" -- essentially putting itself up for sale -- and that created a somewhat unique trading opportunity.
The news sent shares down some 6% that day, a surprisingly negative reaction and certainly not the response hoped for by the bank's board. But it did also set off a round of speculative call-buying and a jump in implied volatility. Over the past week, New York Community Bank's options have had an average daily volume of 20,000 contracts, nearly 20 times the daily average for the prior three months. The implied volatility shot up to a 52-week high of 60% from its three-month average of 30%. The implied volatility has receded slightly over the last week, but is still a sporting a relatively rich 56% for the June options.
Most attributed the share-price decline to the fact that just two weeks earlier, New York Community Bank said its securities portfolio, which is mainly made up of mortgage-related loans and products, carried an unrealized loss of $131 million that resulted from the recent rise in interest rates. This led many to interpret New York Community Bank's decision to put itself up for sale -- a reversal for a company that had only recently been an active acquirer -- as a clear sign of trouble.
New York Community Bank's interest risk exposure has been painfully evident to its shareholders since April 2, when the strong monthly employment data precipitated the recent rise in bond yields. Since that time, its stock has tumbled 35%, hitting a closing low of $22.49 this past Monday.
Working with Some Knowns
So what makes this interesting to option traders? We're presented with "expensive options," which sport a relatively high volatility created by a potential merger. However, this particular situation, while still uncertain, presents a much clearer picture than one in which we'd be speculating purely on rumor.
First, we know which bank might be bought: New York Community Bank. Second and more important, the price it might fetch is developing some reasonably defined parameters. Investors' negative reaction provides the first clue that the company probably won't command a huge premium. Right now, most analysts are estimating that an acceptable bid would be $25 to $30 per share.
You might expect New York Community Bank, with some 140 branches in the demographically attractive New York metropolitan region, would be a highly coveted asset, and supposedly some 10 possible acquirers have already signed confidentiality agreements so they can look at the bank's books. However, the recent rash of bank mergers, including names like
J.P. Morgan Chase
Royal Bank of Scotland
, has depleted the roster of well-heeled potential buyers that might cause a small bidding war. Add this to the aforementioned balance-sheet risk, and it's highly unlikely that New York Community will clear $35 per share in near term.
Being comfortable that its shares won't exceed a certain level is a crucial requirement when establishing a ratio call spread. As the name implies, a ratio call spread involves buying calls while simultaneously selling a greater number of calls with a higher strike price, but the same expiration. Basically it is the inverse of a
back spread, which aims to take advantage of "cheap" options, an increase in implied volatility and a large price movement through the purchase of more option contracts than the number sold.
On the other hand, the ratio spread -- by selling more options than are purchased -- tries to harvest an expected decline in implied volatility and profits from a merely moderate move in price. Like a straight up one-for one vertical spread, the maximum loss is limited to the amount of the premium paid. The maximum profit is gotten when the underlying price reaches the higher strike or price of the calls sold short.
However, in a ratio spread, not only is the profit capped at the higher strike price, but as the underlying share price increases above the higher strike, the position's value actually starts to diminish. It will then pass through a breakeven point and incur potentially unlimited losses if the stock's price keeps rising.
That said, one possible strategy for New York Community Bank, lately trading at $22.50, would be to buy one June $20 call at $3 and sell two of the June $25 calls at 75 cents each. The position has a total cost or net debit of $1.50, which represents its maximum loss. The table below shows the position's profit or loss for various prices of New York Community Bank at the June 18 expiration day.
If I were trading this position, I'd consider buying the in-the-money $20 call because I think the stock has good support at $22. That would give the position an intrinsic value of $2, or a 50-cent profit. The risk is as the stock climbs above the $28 level, the position starts incurring a loss. For example, if New York Community Bank stock were to jump to $35, the position would have a loss of $7.50 -- or $750 per one-by-two contract spread.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to