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
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.