Through the first two months of 2010, it appears the merger and acquisition party of the late 90s and early 2000 could be raring up once again. As Warren Buffett pointed out in his annual letter to shareholders, bankers don’t get paid for suggesting that companies not do deals, they get paid to encourage companies to do deals. Just today, The Wall Street Journal highlighted that corporations have a large amount of cash on their balance sheets, and are beginning to loosen the purse strings to acquire companies in all-cash deals, rather than using stock that they see as undervalued.

Already in 2010 we have seen several high-profile deals: Schlumberger (SLB) for Smith International (SII), Yara for Terra Industries (TRA), Merck KGaA for Millipore Industries (MIL), and First Energy (FE) for Allegheny Energy (AYE), to name a few. Additionally, we have seen an uptick in the amount of rumors regarding potential acquisitions. One example from only yesterday is RadioShack (RSH), which saw its options activity spike on rumors that Apollo Management was considering bidding for the company.

Back in the heady days of the late ’90s and into early 2000 – while the tech bubble was in full effect – every Monday morning the investment community would be treated to a litany of new mergers or acquisitions. Tech firms were using their overly inflated stock prices as currency to go on acquisition binges of epic proportions. When the tech bubble burst, so did the M&A activity … for a time. Then came round two in the middle part of the decade, as private equity firms used cheap loans as a way to fund leveraged buyouts of companies (usually for cash). Alas, then came the financial crisis, and the party came to a screeching halt once again.

How M&As Affect Options Pricing

The important thing to remember about cash deals is that the realized volatility of cash should be close to zero. Cash is cash. Once a price is set for the shares, the movement should logically drop precipitously. As a result, the implied volatilities for options on companies that are the target of a cash deal typically drop to near zero.

Because implied volatilities will likely fall once a company receives a cash bid, market makers need to consider this when pricing options. The risk for a market maker is if they wind up long longer-dated options (like LEAPS) that have the highest vega of all the options on a particular stock, they could get hurt in a cash takeover.

By way of example, consider sample stock XYZ. The stock is currently trading for $50 in the marketplace, and the out-of-the-money January 2012 65-strike call has a market of $5.00 bid, and $5.20 ask. Let’s imagine that an investor sells the call for $5.00 to the market maker on a Wednesday. The next day, the stock has received a $60 all-cash bid. Implied volatility of that call will fall toward zero, making the call also worth zero (as it has no intrinsic value). So the option market maker is likely to eventually lose the entire five-dollar premium. To make matters worse, the option market maker would likely have sold a little stock against the call to be hedged delta neutral.

As a result of this potential risk to the market makers, they will lower their implied volatility bids for longer-dated options. Using history as our guide, we can see that this is what happened in the mid- 2000s, (also known as “the aughts.”) In names that were possible takeover candidates, we would see an inverted volatility curve. That is, the implied volatility for the near-term options would be higher than the longer-term options.

So what could all of this mean for you? Perhaps this backdrop means if you have names you think could be taken over, rather than just buying short-dated options to bet on a pop in the stock, you could also consider longer-dated buy writes. Buying stock while simultaneously selling longer-dated call options could prove to be profitable under the right circumstances. This strategy, essentially a covered call, is also an alternative way to earn premium if the stock does not get acquired (but does not move lower).  The risk to this strategy is unlimited down to zero once the stock drops below breakeven (the price paid for the stock minus the premium collected for the short call option).

So many of us learned hard lessons through past periods of market turbulence; when history repeats itself how do you plan accordingly?

Photo Credit: xmatt