Thursday, January 21, 2010

Bare Escentuals (BARE) - How Pros Trade a Takeover

BARE is trading 18.11. The LIVEVOL™ Pro Summary is below.

The company is in a deal to be taken over for $18.20 in cash. The Corporate Action Pop-up is included below.

The company has traded over 20,000 options today (not a typo) in the first 2 hours on total daily average option volume of 893. The Company Tab snapshot is below (click the image to enlarge).

Essentially the entire volume was a 20,000 lot purchase of Jun 17.5 calls. The options traded with 1.4 million shares (sold) @ 18.10. The day's biggest trades and Option Tab snapshots are inlcuded below (click either image to enlarge).

The calls traded with stock on an implied 70 delta (1.4million/2 million). That means the trade is really 70 puts for every 30 calls.

The puts have an implied price of:
Puts = calls - parity - cost of carry
= 0.85 - (18.10 -17.5) - .04
Puts = 0.21

That's 0.85 + 0.21 = 1.06 in 30 straddles and 40 more puts for 0.21. The payoff diagram for the trade at Jun expiration is included below.

Max loss is at 17.50 - but analytically, that outcome seems very unlikely. i.e. Either the deal closes for $18.20 or the stock falls hard on a bust. The stock was trading ~13.00 before the announcement.

$17.50: -$860,000 (max loss)
$13.00: +$5,400,000
$18.20: -440,000 (deal price)

So this is a $440,000 loser if the deal goes through with an upside of $5.4 million if the deal falls apart and the stock goes back to the original price. That's a 12.3 to 1 payoff. These are exactly the types of trades pros make on takeovers - "cheap bets" (in this case 0.21 options) to make huge money (in this case $5.4 million).

If you do an odds analysis (outcome tree) - you can create your own probabilities that the deal does/does not go through and try to position yourself accordingly. Remember a bet that is wrong 90% of the time is a good bet if it pays off more than 10:1. Alternatively, a bet that is right 90% of the time is a bad one if the payoff is worse than 1:10.

Play the odds, make appropriate bets with better payoffs than the odds, repeat --> Successful trader.

This is trade analysis, not trade advice. I have no idea what the odds are of this deal going through.

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