Terra Networks'

(TRRA)

proposed buyout of

Lycos

(LCOS)

has forced takeover arbitrageurs to do a little more work than usual.

Usually when an arb wants to play a deal's possibilities, the arb will sell short the stock of the acquirer and go long the stock of a company being taken over. But in the case of the Terra-Lycos deal, options pros said it's impossible to sell short Terra stock.

Larry McMillan of

McMillan Analysis

in Morristown, N.J., said arbs are "having a hard time playing" the deal because it's "impossible" to short Terra. To take a short position, arbs have to synthetically short Terra via the options market.

Under terms of the deal announced Tuesday, Lycos shareholders will receive $97.55 in Terra ordinary shares, or their equivalent in Terra ADRs, in exchange for each Lycos share, subject to a 20% collar. The collar mandates that Lycos shareholders won't receive fewer than 1.433 or more than 2.150 shares of Terra. The companies expect the deal to close in the third quarter.

In this situation, an arb would buy Lycos stock and short the high ratio on Terra, McMillan said. That high ratio, based on a 20% increase in the top end of the collar, from the announced price of $97.55 that Lycos shareholders would receive in Terra stock, would be about $117. That $117 figure is right under the 120 strike, which saw volume of 6,800 put and call contracts Wednesday.

To synthetically short in the options market, an investor would have to sell calls and buy puts.

Arbs picked Terra's 120 strike because the possibility of exercise is nonexistent, said one

American Stock Exchange

floor source. Terra was down 3/8 to 46 5/8, while Lycos was up 5 1/32, or 8.7%, to 62 5/8.

On Thursday, on the

Chicago Board Options Exchange

, 2,800 of Terra's September 120 put and call options have changed hands. The calls late Thursday morning were trading at 1/2 ($50), up 1/4 ($25), while the puts were trading at 78 3/4 ($7,875), up 3/4 ($75). On the Amex, 1,120 of the September 120 puts and calls traded earlier Thursday morning.

According to a

Deutsche Banc Alex. Brown

report on the deal by analyst Andrea Williams Rice, the 20% collar adds downside protection for Lycos shareholders and protection to Terra. Rice pointed out that as long as Terra's stock is trading in the range of 45 to 68, Lycos stockholders will get the 1.7 share exchange rate, or 97.55. And if Terra's stock falls below 45, the ratio jumps to a maximum of 2.15. If Terra surges above 68 a share, the ratio falls to a minimum of 1.433.

"Neither party can walk away from the deal based on stock price, although Lycos has the ability to entertain a better offer," according to Rice.

As for Lycos options, most of the action Wednesday was on the call side. According to McMillan Analysis' daily research report, which is sent out before the open, total volume in Lycos options was 51,090 Wednesday, with 39,624 of those contracts call options.

A good portion of the activity Thursday has been in the May options, which expire tomorrow. Most of the volume Thursday has been on the call side.

In the McMillan research note, he recommended to clients that if they expect the deal to go through, they should buy Lycos stock itself because anticipation in the past week has driven up the price of call options.

"Unfortunately, the options are so expensive as to be prohibitive for purchasing -- even deep in-the-money LCOS calls, which would only serve to limit downside risk if both stocks completely collapse," McMillan wrote. "The cheapest thing is LCOS stock itself."