A company needs two things before pursuing a takeover strategy: money and courage. The stock market has supplied the former in the form of rising share prices, and a recovering economy is bolstering the latter. This combination of more valuable currency and increased optimism has many believing that the pace of merger and acquisition activity will continue to pick up in the coming months.

The numbers are already showing some momentum. M&A activity during the fourth quarter of 2003 rose to $209 billion -- more than double the year-earlier period. "Balance sheets have improved, borrowing costs are still low, and the economic outlook continues to improve; this is a recipe for M&A activity," said Steve Supelo, a manager at SF Investments, a Chicago investment firm.

The need for top-line growth will also drive activity as "bottom-line improvements through cost-cutting have been mined about as deep it can go, and any further reduction in spending would leave companies too constrained to leverage a recovering economy into earnings growth," added Supelo.

Of course, rumors come and go, and courtships can take time to blossom. "Everyone is being more diligent, so lead times are going to be longer" than at the peak in 2000, said Supelo. Besides considering valuation, companies are taking their time to consider antitrust issues, possible transaction alternatives and the competitive landscape before rushing headlong into a union.

Good Deal? Who Cares?

For many professional traders, specifically hedge funds that focus on arbitrage strategies, the success of playing takeover stocks rests on their ability to accurately value the target company, identify the prospective acquirer and what it might pay, and then capture an incremental price spread between the two. This strategy requires size and accuracy, and a busted deal can result in huge losses.

But as an options trader, I really don't give a hoot about enterprise value, cash flow, who pays what or even whether the deal makes any sense. In fact, gauging whether a deal will actually be consummated isn't a primary part of the calculus of deciding whether an options position should be established.

Instead, the focus is on identifying a shift in the configuration or skew of the option prices. The skewing of option prices, which I discussed

in an earlier column, provides a unique opportunity to sell options that are "expensive" while simultaneously buying ones that are "cheap." This, of course, is one of the essential fundamentals to high-reward/low-risk option investing.

Once a stock enters the rumor mill, it's not unusual for traders to purchase calls, hoping for a big pop in the target stock if a deal is announced. The demand for low-priced options actually drives up the implied volatility of the front month (those with the shortest expiration period), creating a horizontal skew in which those "cheap" near-term calls actually become expensive relative to those with a longer expiration date. The combination of that skew with the prospect that rumors can keep a floor under a stock sets up an attractive opportunity for establishing a calendar spread (buying and selling an option on the same stock with different maturities).

And Abraham Begot Jacob

What first got me looking at calendar spreads on M&A plays was the notion that takeover rumors can create skews in option prices.

Sovereign Bank

(SOV)

has long been rumored as a takeover candidate because of the industry trend toward consolidation and multinational firms filling in their footprints through the acquisition of regional franchises. When

Bank of America

(BAC) - Get Report

announced its intention to acquire

FleetBoston

in October, it renewed the rumblings surrounding Sovereign, causing its stock to gap up that same day, and put the premium juice into its options.

Sovereign Moves on Merger
A bank megamerger sparked further interest

Though the initial excitement has receded, the implied volatility of Sovereign's January calls remains at a relatively high 43%, while an implied volatility of 35% and below is being applied to the options with further expiration dates. As of Tuesday, with Sovereign trading at $24.25, you could sell the January 25 call for 40 cents, and buy the April 25 call for $1.40. If January expires worthless -- just eight trading days from now -- the remaining position would be outright long the April 25 calls. The net cost of $1 also represents the maximum loss. If Sovereign works higher over the next four months on rumors, reality or just bull market momentum, the profit potential is unlimited.

Every consummated deal can spawn a multitude of possible alliances as other companies feel the need to partner up. Since most of these proposals or rumors fail to materialize, one would either go crazy trying to determine which deals will really happen or go broke trying to play them all.

For example, some names currently being bandied about as potential takeover targets include

AT&T Wireless

(AWE)

,

State Street

(STT) - Get Report

and

ImClone

(IMCL)

.

Two other names still sport horizontal skews:

U.S. Bancorp

(USB) - Get Report

and

Unisys

(UIS) - Get Report

. Unisys' January calls have an implied volatility of 34% while the April calls are at a slight discount of 31%, making it possible to buy the $15 strike calendar spread for $1. The source, reason or probability of any of these companies actually being bought out is indeterminable and basically immaterial.

Don't Guess, Wait for the Tell

A new name,

Iron Mountain

(IRM) - Get Report

, popped up on Tuesday when the stock jumped some 7.5% to $42.63. This sent its January 45 calls to 30 cents, giving them an implied volatility of 37%, while the April 45 calls could still be bought for 95 cents, or a 21% implied volatility, meaning you can wind up owning the April 45 call for around 50 cents.

This brings up an important point: Sometimes it takes the rumor to hit and the initial price move to occur before the skew is created. But this is fine; a calendar spread is most effective for stocks with a stable to steadily climbing price, so avoiding the first spike up is actually preferable.

Sovereign, like any of the other takeover candidates, never actually needs to be acquired for the positions to become profitable. Applying a calendar spread makes sense because it doesn't require the huge capital outlay or exposure to large losses involved in the outright purchase of underlying shares. And because of its low cost and limited risk, you can establish positions involving a number of takeover candidates. The ability to spread your chips around the table should not be overlooked.

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

Steve Smith.