EC's Pressure on GE/Honeywell Plan Sends Risk Arbs Into Tizzy - TheStreet

The risk arbs were sweating it out today as

General Electric's

(GE) - Get Report

deal to buy


(HON) - Get Report

appears to have

gone awry.

Despite having already gained approval in the U.S. and Canada, the $42 billion deal has hit a snag in Europe, with the

Eurpoean Commission

reportedly asking GE to sell a large portion of its businesses, particularly its aerospace outfits. GE says it isn't confident that the deal will go through because its offer falls well short of the EC's demands.

Both firms have seen plenty of interest in the options market over the course of the last two weeks as they sought approval for the deal. The implied volatility in Honeywell options has risen dramatically in the last week, jumping to 90 from 53 as investors speculated on the outcome of the regulatory meetings. A spike in volatility typically prefaces a major announcement from companies such as earnings news, mergers and acquisitions, or the unveiling of a new product.

Arbitragers attempt to profit by playing mergers. The goal is to capture the largest possible spread. More than one trader said today that some arbitragers were looking to "capture the spread" by going long Honeywell and short GE, the usual tactic. In the options market, arbs will hedge a long position by buying puts or hedge a short position by buying calls. (A put gives the holder the right but not the obligation to sell the underlying stock, while a call give the holder the right but not the obligation to buy the underlying stock.) The bottom line is that the arbs use options to unwind their positions after an unexpected turn of events, which in this case is the merger seemingly coming apart.

Honeywell's June 40 calls were actively traded, as more than 20,000 contracts changed hands on open interest of 5,158. The stock closed Thursday down $5.16, or 12%, to $37.10. These calls began the day in the money, or above the strike price, but have landed out of the money (below the strike price) due to the speculation that the deal is in jeopardy. The July 40 calls traded over 14,000 contracts on open interest of 1,506. The premium on those calls can be found in the range of $2.25 ($225) and $2.50 ($250).

GE options were active as well. The June 50 calls traded about 25,000 contracts on an open interest of 52,746, with the premium going for 25 cents ($25) to 35 cents ($35). The July 50 calls traded about 21,000 calls on open interest of 58,351, with the premium ranging from $1.70 ($170) and $2 ($200). The stock closed Thursday up $1.01, or 2.1%, to $48.86. According to a trader at the

Chicago Board Options Exchange

, investors are selling out the June 50 calls they bought two days ago, whereas the July 50 calls are mostly the arbs at work.

Earlier this month,

reported heavy call activity in June 55 calls, as some investors believed the share price would make a significant move upward. With one day left before expiration, GE shares are trading at $49.60. Clearly, they were wrong. However, they did take in enough premium by selling the June 50 calls for a profit. The trade enabled them to take some profit while making a speculative bet on the stock.