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