The Options Playbook for Mergers, Buyouts & Takeovers

Merges, takeovers, and buyouts are explosive market events that often create high-volatility trading opportunities. The stock prices will often surge when traders catch wind of an announcement like one of these, which can further lead to an increase in option premiums and a significant spike in implied volatility.

As is the case with a lot of other key market events in the options world, mergers, buyouts, or takeovers can provide traders who make money around events with a lot of opportunity, as well as some considerable risks. Using the right strategies for trading options correctly around these corporate events will result in traders realizing decent profits while also limiting their amount of downside exposure.

Keep reading to learn how to use options to profit from and hedge during corporate consolidation events.

Understanding the M&A Landscape

The mergers and acquisitions (M&A) landscape is a segment of the business world that is well-known for being extremely complex, but also dynamic for trading options. Trading takeovers requires the understanding that not all M&A deals are the same. Stocks and options are going to behave differently as a result of how the transactions are structured.

Types of M&A Transactions

• Friendly Mergers: These mergers are characterized by two companies agreeing to the terms of the deal. The acquiring company and the target company engage in a cooperative transaction where the board of directors and the management teams are completely on board with the merger proposal.
• Hostile Takeovers: Unlike the friendly merger, a hostile takeover is where the acquiring company goes about getting the target company, but it goes against the will of the target company’s board of directors or management team. The acquiring company deals directly with the target company’s shareholders instead of working with the target’s management.
• Cash Buyouts: A transaction where the acquiring company pays cash to the target company’s shareholders in exchange for their shares. It is the opposite of a stock acquisition, where the shareholders of the target company get shares in the acquiring company instead of cash.
• Stock-for-Stock Transactions: Also known as a “stock swap,” this kind of merger or acquisition is where one company’s shares are exchanged for the shares of another company. Unlike cash buyouts, these transactions are done where the acquiring company offers its own stock to the shareholders of the target company.

Depending on what kind of merger deal is taking place, the impact on stock prices before and after announcements could be good or bad. You typically see the target company getting a boost in its stock price due to the acquiring company offering it a premium over its current market value. Meanwhile, the acquiring company might experience a short-term dip due to the costs that are wrapped up in merging with the other company.

Real-World Example

A good example of a merger and how it affected the stock prices of the companies involved occurred in 2022 and 2023, where there was a deal between Microsoft and Activision Blizzard. The results were that the shares for ATVI gapped higher after the announcement but traded at a discount thereafter. The stock price remained consistent for several months, holding at the $95 buyout price. This came to be seen as reflecting regulatory uncertainty.

M&A Deal Phases

When it comes to mergers, takeovers, and acquisitions, you’ll see each one follow a general phase as each part of the deal falls into place between the acquiring company and the target company. You can expect these steps in the process as an options trader who is looking to trade around the event.

1. Rumor or Leak: There can be rumors circulating that some sort of merger is going to happen in the not-so-distant future, or there could be a leak confirming a merger or sorts. Once this news leaks out, it can have an immediate impact on the stock prices and can result in implied volatility going up. These stocks can be much more expensive to trade with this increase.

To be clear, this isn’t an official stage in the merger process as the news doesn’t come from the companies that are emerging together, but instead stems from leaks or rumors that might be coming from people on the inside. These can possibly jeopardize the deal’s integrity, which could also have an impact on the stock price.

2. Official Announcement: This is typically followed by some kind of official announcement after the signing of the agreement has taken place. It’s an announcement for the general public as well as the shareholders involved, customers, investors, and employees. Anyone can learn the rationale behind the M&A and any significant changes that the shareholders can expect going forward. This event brings a lot of clarity to the situation and could involve IV going down for a time.
3. Regulatory Review: Government agencies then get involved to make sure that the proposed transaction is in agreement with antitrust laws and other relevant market regulations. This is a period of waiting for traders, and it could result in the stock price coming down from where it was previously when the rumor, leak, or the official announcement occurred.
4. Deal Close or Collapse: This is the point where the deal is finalized, either for good or for bad. So long as the terms of the deal are met by both parties, the merger should go through, but the deal could fall apart. It’s during this time that traders need to keep an eye on the proceedings and then choose a suitable strategy for dealing with whatever comes.

Each phase creates distinct trading setups and volatility profiles. For instance, the phase where there is speculation about what may happen due to rumors circulating or information being leaked might be a good time for traders to accumulate positions in the target company and then trade around speculation and the current market sentiment.

Key Market Reactions to Watch

It is usually best to act swiftly when a new deal is made known in the news cycle. The market reaction is sudden and can take an unsuspecting trader by surprise if they aren’t paying close enough attention.

Trends with the Target Company

• What happens most of the time is that the price gaps upward, which means that it jumps forward toward the deal price. It is critical to note, however, that it will jump close to the deal price, but it rarely ever goes all the way.
• Ahead of the official announcement, option IV spikes, and this could be due to rumbles of a merger or acquisition occurring, or it could stem from an information leak. However, over time, the IV will begin to decay if the deal happening begins to appear like it’s going to happen.

Trends with the Acquiring Company

• Traders will usually see a price decline with the acquiring company, and this is typically because that company is putting a lot of capital forth to purchase the target company and to make the deal happen. The price is guaranteed to drop in stock-based deals when traders are concerned with dilution.
• Although the price might be in decline, it can see an uptick when there is increased IV due to uncertainty about the acquiring company’s rationale behind the deal or their current financing plan.

Additional Factors to Keep in Mind

Traders should also consider these factors when they’re trading around mergers, takeovers, or acquisitions. The stock price can be affected by these things as well, and not just from the dynamics that are at play with the acquiring and target companies.

• Pressures from Arbitrage Deals: Pricing dynamics can change for retail traders when hedge funds or institutional investors enter long positions or set up short acquirer positions. It’s something that happens behind the scenes, more or less, but it can affect the stock price that someone might not necessarily think about unless they’re aware of institutional activity or smart money moves.
• Deal Spreads: A perceived closing risk can stem from the difference between the target company’s current price and the offer price. The spreads that reflect these price gaps can create doubt in some traders’ minds about whether or not the deal is happening.
• Risks That Stem from Regulations: Some deals can be held up in red tape or blocked entirely by antitrust reviews. These occurrences can also hurt the stock prices that traders tend to deal with around acquisitions or mergers.

Top Options Strategies for M&A Events

What are the best trading strategies or techniques that you can use when trading the stocks of acquiring or target companies during a merger or acquisition scenario? Let’s check out the prime opportunities that you can capitalize on to trade around these big events and come out on the other end of the proceedings with a secure profit in hand!

Long Call or Call Spread on Rumored Target

Either of these strategies can be used to great effect when anticipating an announcement on a target company that is going to be acquired by another company. Traders can clean up well when they buy ATM calls on the target company, specifically, because they can capture upside if the deal is confirmed to be going through.

However, these strategies can be tricky to employ, and traders should only go forward with them if there are credible rumors circulating about a proposed merger.

• Risk: The biggest risk with using the long call or the call spread on the rumored target is that the deal might not emerge as anticipated by traders on the other end of the rumor. If no deal occurs, then IV crush can take place and destroy the trader’s investment.

Example Setup

If a trader is looking to use a call spread on a rumored target company, they can effectively offset any inflated premiums by combining a long ATM call and a short OTM call.

ATM call + OTM short call to offset IV. Traders can express a bullish view on the rumored merger, but they can also reduce the risk of the trade and reduce the initial cost to enter the spread.

Put Spreads on the Acquirer

Using put spreads on the acquiring company can be used to bet on a decline or hedge exposure when you expect that company’s stock to drop in value following the official announcement of the merger. A bear put spread, specifically, can be a good move that lets traders benefit from a decline but also limit their costs. This strategy of using put spreads on the acquiring company is commonly seen with large stock-based deals and is usually executed to maximum effect with overvalued paper deals.

Example

A trader is putting together a put spread on the acquiring company because they are anticipating a decline in the stock’s value due to the capital the company is putting forward to buy out the target company. This put is constructed from a long $50 put and a short $45 put if the acquirer is currently trading near $50.

Merger Arbitrage with Options

Merger arbitrage is a way of replicating long or short arbitrage using options contracts, and this can be done instead of using shares. A synthetic long position on the target company involves the trader buying a call and selling a put on the same strike price, while a synthetic short position on the acquiring company has the trader buying a put and selling a call option. The advantage for the trader is that using options instead of the stocks themselves has a much lower capital requirement, at least compared to using stock-based arbitrage.

Using Risk Reversals or Long Volatility Plays

Risk reversals or long straddles/strangles might be the better path to take when you’re doing merger arbitrage using options:

• Risk Reversals—These are best to use when there is a clear bias in the underlying in terms of potential direction. Risk reversals can also be beneficial to use as a hedge against market movements that could go against your outlook or to reduce the upfront costs of entering the trade. Using a risk reversal would involve buying an OTM put option and selling an OTM call option at the same time. It offers downside protection and comes with a defined risk/profit profile.
• Long Straddles or Strangles—These moves should be used when the trader is expecting a big price movement in the underlying, but the ultimate direction of where the stock price will go remains unclear. Long straddles or strangles are ideal for a situation where there is skepticism about the deal’s success. Strangles let traders benefit from volatility while reducing the cost of the trade, while straddles can secure a larger profit from higher volatility, but at a higher premium cost.

Post-Announcement Speculation

Now, let’s talk about a strategy that you could use once the merger or acquisition announcement has passed and the stock price begins to stabilize as the uncertainties begin clearing up. During this period of the merger or acquisition, implied volatility, which was once surging or spiking, begins to wane or outright collapse, bringing down the value of the stock.

This can be a prime time to use the following strategies for speculative trading moves:

• Short Puts: This one is best used on target companies where the deal is done with cash instead of stocks. A short put in this environment can generate income for the trader, but they’d have to be willing to take on a potential assignment to gain access to the income.
• Iron Condors: Setting up this type of spread lets traders gain premiums in the post-announcement environment, but it only works best when the stock is trading within a tight range. This is a way for traders to buy volatility collapses and come out on the other end with a profit.

Risk Management in M&A Option Plays

One of the biggest dangers that comes from trading around companies that are planning on merging with another is that the deal might not close as expected. This is what’s known as a binary risk, and you see it happen a lot with options traders who are interested in making money around M&A events. We would like to outline the best practices that traders should stick to when they are attempting to make a profit by trading around mergers and acquisitions.

Best Practices

• Dealing with Deal Delays, Collapses, or Regulatory Rejection: Know in the back of your head that these outcomes are possible, and have an exit plan set up ahead of time to deal with these outcomes. You can set yourself up to either limit losses if the market goes against you or to secure a tidy profit by using strategies that profit from a decline in value.
• Diversification Across Deal Types: Just as you would diversify your investments across multiple industries or asset types, you must keep your M&A trades diversified across multiple deal types, including the different kinds of mergers we previously discussed. Avoiding overexposure to a single deal is a good thing.
• Position Sizing for Binary Outcomes: Go into each of these trades using a conservative position size to ensure that you don’t completely burn yourself when one of these deals goes south. Keep positions small relative to account size (only about 1% or 2% of your total capital balance).
• Avoiding “Deal Jumpers” Without Confirmation: The more that a trader can monitor deal timelines and official filings (see the SEC’s EDGAR tool), the better they can assess the possibility of these deals happening and avoid going with a merger or acquisition that eventually falls through.
• Have an Exit Plan Before Unexpected Headlines Hit: We already alluded to this practice in the first point, but we cannot emphasize enough the importance of having a contingency plan in place in case the worst-case scenario were to unfold. Set up stop-loss limits to trigger an automatic sell-off once your losses have reached a certain level.

Real Case Studies

Although there are plenty of M&A trade deals that seem like they’re going to be a sure thing, they always carry the risk of being jeopardized by regulatory red tape or more politically motivated reasons. There are plenty of lessons that traders can learn from past M&A trades in terms of timing these positions correctly and not letting any premium that’s built into the position erode too quickly.

We’d like to take this time to highlight and review a few examples of both successful and failed deal-related trades, specifically looking at deals between T-Mobile and Sprint and Broadcom and Qualcomm.

• T-Mobile/Sprint: This deal happened between 2018 and 2020—the reason the deal took so long to close was that there were regulatory battles over the course of a few years that resulted in volatility cycles, which impacted each company’s stock prices. Experienced traders saw this time as a prime opportunity for using diagonal spreads while the deal was on hold. This multi-year option opportunity resulted in these traders capturing upside while also enjoying lower decay risks.
• Broadcom/Qualcomm: This is a good example of a failed deal that eventually burned a lot of unsuspecting retail traders. This was a hostile takeover attempt by Broadcom to take over Qualcomm, but it was blocked by regulators in the US when it occurred in 2018. As the deal’s odds of going through began to collapse, experienced traders read the writing on the wall, and they began to use put spreads on Qualcomm to get downside protection. The regulatory block and fallout ended up burning a lot of inexperienced traders, though.

Best Practices & Timing Tips

Getting trades right around mergers, takeovers, or acquisitions can be a challenge if you’re not used to doing so, which is why we’ve outlined the best practices and timing tips that you need to know as you go forward with M&A trading. It’s best to use a wide range of indicators and continually monitor the proceedings to get the timing right, be it through automated systems or through manually checking.

• Monitor Deal Progress: Traders can get an idea of how the deal is developing by tracking press releases, analyst commentary, or SEC filings. The more you know of how the deal is coming along, the better informed decisions you can make, and the quicker you can either embrace your current strategy or pivot away from it.
• Event-Driven Calendars and Catalysts: Anyone trading a merger or acquisition should develop and maintain an event calendar that includes all regulatory deadlines and pending deals. This helps traders to keep better track of what’s going on so they can make timely decisions when the moment is right.
• Tools for Tracking Merger Arbitrage Spreads: Traders will want to use technical setups, such as support or resistance levels, and then pair those with fundamentals like deal analysis. Combining technicals with fundamentals during rumors can help traders avoid chasing initial spikes. Using these tools can result in better entries as the market gets clearer on the direction and strength of the deal.

Final Thoughts on M&A Trading

Many exciting, yet dangerous trading opportunities can arise from buyouts, mergers, takeovers, or acquisitions, and it’s key for traders to get the deal progress correct to use the right strategies at the right times. M&A trading requires discipline and a risk-managed playbook for best results. Traders can do well trading around these events, so long as they have the patience to do so and a good sense of hedging or volatility forecasting.