Chapter 27: Arbitrage 447 
However, when XYZ rallies to 60, his profit increases. He would still make the 
$1,600 on LMN as it rose from 22 to 30, but now would only lose $550 on the XYZ 
put - a total profit of $1,050 as compared to $600 with an all-stock position. 
The disadvantage to substituting long puts for short stock is that the arbitrageur 
does not receive credit for the short sale and, therefore, does not earn money at the 
carrying rate. This might not be as large a disadvantage as it initially seems, however, 
since it is often the case that it is very expensive - even impossible - to borrow the 
acquiring stock in order to short it. If the stock borrow costs are very large or if no 
stock can be located for borrowing, the purchase of an in-the-money put is a viable 
alternative. The purchase of an in-the-money put is preferable to an at- or out-of-the­
money put, because the amount of time value premium paid for the latter would take 
too much of the profitability away from the arbitrage if XYZ stayed unchanged or 
declined. This strategy may also save money if the merger falls apart and XYZ rises. 
The loss on the long put may well be less than the loss would be on short XYZ stock. 
Note also that one could sell the XYZ July 55 call short as well as buy the put. 
This would, of course, be synthetic short stock and is a pure substitute for shorting 
the stock. The use of this synthetic short is recommended only when the arbitrageur 
cannot borrow the acquiring stock. If this is his purpose, he should use the in-the­
money put and out-of-the-money call, since if he were assigned on the call, he could 
not borrow the stock to deliver it as a short sale. The use of an out-of-the-money call 
lessens the chance of eventual assignment. 
The companion strategy is to buy an in-the-money call instead of buying the 
company being acquired (LMN). This has advantages if the stock falls too far, either 
because the merger falls apart or because the stocks in the merger decline too far. 
Additionally, the cost of carrying the long LMN stock is eliminated, although that is 
generally built into the cost of the long calls. The larger amount of time value pre­
mium in calls as compared to puts makes this strategy often less attractive than that 
of buying the puts as a substitute for the short sale. 
One might also consider selling options instead of buying them. Generally this 
is an inferior strategy, but in certain instances it makes sense. The reason that option 
sales are inferior is that they do not limit one's risk in the risk arbitrage, but they cut 
off the profit. For example, if one sells puts on the company being acquired (LMN), 
he has a bullish situation. However, if the company being acquired (XYZ) rallies too 
far, there will be a loss, because the short puts will stop making money as soon as 
LMN rises through the strike. This is especially disconcerting if a takeover bidding 
war should develop for LMN. The arbitrageur who is long LMN will participate nice­
ly as LMN rises heavily in price during the bidding war. However, the put seller will 
not participate to nearly the same extent.