There has been an increasing use of options to both identify and participate in profiting from the current buyout frenzy. Most of the focus has been on looking for a surge in the volume of call activity and an increase in the implied volatility in near-term options on the belief that these are obvious signs that a company is a takeover target.

There have been many instances of these "unusual" signs in trading activity, such as

occurred in

First Data

(FDC) - Get Report


Texas Utility

( TXU). But these transactions often occur too quickly and too close to the event for the average investor to take advantage of the "tell" being provided by the options market.

Some people might find solace in knowing that the activity in both of these cases was brazen and obvious enough to get the


off its tuchus and launch official investigations, but that retribution does little to line our pockets or buy our babies new shoes.

A more subtle way to identify takeover candidates is to use the pricing of the LEAP options as a predictive tool for which companies investors believe are buyout targets. That is, look at the implied volatility of options across the option chain over several expiration periods with an eye toward the skew. You're watching for the implied volatility of longer-dated options to be lower than the nearer-term.

For equity options, the typical or normal skew has longer-dated options awarded a higher volatility than shorter-term options. Remember the connection between time and implied volatility. This also assumes there is no known upcoming event such as an earnings report or court ruling within a specific time period. Implied volatility can be viewed as the interest rate on bonds in that the longer the duration or expiration, the greater the impact a change in yield will have on the value or price of the underlying investment product.

With this in mind, remember that when a

takeover is announced, especially a buyout that contains a significant cash portion, it will cause a steep decline in implied volatility. That means options across all time frames will basically trade at intrinsic value plus the carrying costs based on the forecasts for the probability and time frame of the deal's closing date.

Traders have become hip to the game that IV will collapse on a buyout and have been selling calendar spreads, that is, buying near-term options and selling longer-term options for a net credit on names rumored to be buyout candidates. It is a much more conservative approach to playing the takeover game; the maximum profit is limited to the credit collected.

One suggestion for keeping the risk or loss to a manageable level: If a deal fails to materialize by two weeks prior to the front month's expiration, then I'd close the position.

The insurance and regional financial services sectors have a number of names where the option chain displays this type of reverse skew, indicating that investors are anticipating more buyouts and consolidation.

For example,

Marsh & McLennan

(MMC) - Get Report

is currently trading around $32.50. You can buy the July $35 call for 60 cents per contract, which gives it an implied volatility of 31%, and simultaneously sell the January 2008 call for $1.80, which gives it an implied volatility of just 20%. That results in a net credit of $1.20 for the calendar spread.

This seems to fly in the face of the standard advice to buy options that are cheap and sell the more expensive options based on their relative implied volatility. But this is a case in which one might want to interpret the price configuration or price skew as predictive; there is a good possibility that MMC will be taken over or at least receive a buyout bid. If that should occur the IV would decline and the value of the spread would flatten out. The longer-dated January 2008 options sold short would lose a substantial amount of their time premium.

Steven Smith writes regularly for 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 appreciates your feedback;

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