A Cybersecurity Acquisition Creates a Triple Digit Income Opportunity
When traders see news of an acquisition, they may quickly look at the stocks involved in the deal to assess whether or not an arbitrage opportunity exists. Arb trading opportunities for individual investors are relatively rare and it is possible traders quickly begin to ignore news of deals.
An alternative, which is illustrated below, is to consider how the stock of the acquirer reacts. At times, there will be an opportunity for an income trade. Interestingly, these income trades could combine relatively high income with relatively low risk, which is a combination that appeals to some traders.
The news, as The Street reported is related to a cybersecurity deal.
“Analysts said [recently] that F5 Networks’ (Nasdaq: FFIV) $1 billion cash acquisition of cybersecurity company Shape Security is a good strategic move but it will be costly in the near term.
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The Seattle-based company announced the acquisition late Thursday and said it expects to close the transaction in the first quarter of 2020, funded by cash on hand and $400 million in financing.
The Santa Clara, California-based Shape Security was founded in 2010.
F5 Networks said that privately-held Shape Security’s application protection platform evaluates the data flow from the user into the application and uses cloud-based analytics to discern good traffic from bad.
Morgan Stanley analyst James Faucette said he was maintaining his equal-weight rating on F5 because while the transaction will be beneficial to growth and valuation potential it will have an impact on earnings power in the near term.
“While the acquisition follows a strategy to monetize F5’s platform and is beneficial to longer term valuation potential,” he said in a note to investors, “we think the impact to earnings power is likely to prevent valuation benefit in the near term.”
Faucette, who maintains a $130 price target on F5 Networks, said the profitability of the company’s new services, particularly those it has acquired, “are not to date as profitable as existing businesses, challenging ability to grow earnings.”
Analysts at Piper Jaffray said that while F5 Networks’ stock is likely to trade down as a result of the earnings impact, they are positive about the strategic vision and the free cash flow accretion.”
Jefferies analysts said that the acquisition makes strategic sense, but noted that the deal will require “many years of crisp execution in order to get a return on investment.”
The stock is already well below its highs and this news could lead to lower lows.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in FFIV
For FFIV, we could sell a January 17 $135 call for about $5.75 and buy a January 17 $140 call for about $2.90. This trade generates a credit of $2.85, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $285 The credit received when the trade is opened, $285 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $215. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($285).
This trade offers a potential return of about 132% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if FFIV is below $135 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $215 for this trade in FFIV.