Options Forum: Managing Mandalay

Steve:

I read your article on MBG options. How would you benefit from the price difference between the '05 and '06 expiration dates? Would you buy one and sell the other?

-- J.C.

The reader is referring to a recent article in which I suggested there might be an opportunity for a small arbitrage position in Mandalay Bay ( MBG) options in the wake of the proposed takeover by MGM Mirage ( MGG).

The suggested strategy was to buy the Mandalay Bay $65 calls, which expire in January 2005, while simultaneously selling an equal number of Mandalay Bay $65 calls, which expire in January 2006. The theory is that with MGM making a bid of $71 a share, they should each have an equal potential maximum value of $6 a contract.

When I wrote that Monday column, Mandalay Bay was trading at $68.10, and January $65 calls expiring in 2005 were $4.10 and the January $65 calls expiring in 2006 were offered at $5.30, for a $1.20 spread between the two. As I wrote, "the price discount and potential arbitrage between the 2005 and 2006 calls is an indication of the odds that the deal will not be approved and closed before January 2005."

But the theory behind the suggestion was that as time moves forward, it will bring into clearer focus how the deal will play out. If there are no major roadblocks to completion, you'd expect shares of Mandalay to creep higher toward the $71 takeout price; therefore the spread between the two calls would narrow in the coming months.

On Friday, with Mandalay now at $68.32, the January 2005 call is trading at $4.80 and the January 2006 call is at $5.90. So, even over the last few days (MBG didn't "officially" accept the MGM bid until Tuesday), the spread has narrowed slightly as some of this arbitrage trading may be beginning to take place.

This price action, in which the shorter-term option's value actually increases relative to an option with the same strike but with a much longer expiration date, is, of course, completely the opposite of the normal price behavior you'd expect from a calendar spread; this is because of the price cap placed on Mandalay's shares by agreeing to the $71-a-share offer. Once the deal was accepted at that price, the value for all calls with a strike above $71 became essentially worthless and the implied volatilities for all MBG options, even those that are in-the-money, crashed from the level of 40 they were sporting before MGM Mirage's bid, to below 10. Currently, both $65 calls for the January 2005 and January 2006 expirations have implied volatilities of just 10 and 7, respectively.

However, the risk (as some astute readers chided me for not originally mentioning) is in the deal hitting a major snag or completely falling apart. At that point, the options would assume their normal price relationship in which the January 2006 calls you are short would be awarded their full 12-month time premium over the calls expiring in January 2005. This would likely also coincide with a decline in Mandalay's stock price and a sharp spike in the options' implied volatility.

Let's look at the theoretical value, and therefore the potential risk to the position, if the deal gets called off or falls apart on Dec. 20, 2004. Based on the assumption that Mandalay tumbles to $60 and the implied volatility shoots to 50 on the January 2005 $65 call, which now has just one month remaining until expiration, it would be worth about $1.70 a contract. Meanwhile, the $65 call, which doesn't expire until January 2006, would be worth $11.25, widening the spread to $9.55 at that point in time. This means that if you had bought the January 2005 call and sold the January 2006 for a net credit of $1.20, you'd be facing a loss of $8.35 a spread.

With the price differential now down to about $1.15 (which is your maximum profit), but an entire year between the two options, this play should only be considered by those that can do sufficient size, and are attuned to the nuances of arbitrage, for it to make sense. As I wrote in my original article, you shouldn't consider this a trade or directional bet, but rather a possible arbitrage opportunity that offers a "small statistical edge to capture a slim profit margin over time."

Like traditional takeover-based arbitrage positions, which usually involve buying and selling the underlying stock of the companies involved in a merger and carries "deal" risk, this options play also carries the risk of timing. The quicker and smoother this deal progresses, the better; any bumps over the next six months that push back the closing date will cause the spread to widen.

Given this risk/reward scenario, you might even consider taking the other side or buying some puts as a speculation trade, and hope that the deal falls apart. The houses holding the cards on MGM and MBG might consider this a sucker's bet, but every once in a while someone does manage to walk out of the casino a big winner.

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 1989 to 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@thestreet.com.

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