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A Legal Battle Points to a Trade

A Legal Battle Points to a Trade

There are times when the biggest factor in a stock’s trend becomes its interaction with another company. The most obvious example of this is when a buyout is announced. At that point, the targeted company’s stock tends to move in line with the offer made by the acquirer and the likelihood the deal will be completed.

A less obvious example of this relationship is when two companies engage in a protracted legal battle. This is what we have seen happen with Qualcomm and Apple, Qualcomm and perhaps Samsung, and now Western Digital and Toshiba.

Western Digital Corporation (Nasdaq: WDC) is locked into what has the potential to be a long running legal battle with Toshiba over the fate of a joint venture between the two companies. There is little reason to doubt that both sides have large and talented legal teams. The result is impossible to predict but one thing does seem clear – Western Digital’s stock will be affected by the legal wrangling.

Western Digital makes flash memory, the kind of memory used in personal computers, mobile phones, video games, scientific instrumentation, industrial robotics and medical electronics. The company currently has a market share of about 12% through its SanDisk division.

Source: Bloomberg

Toshiba, the second largest chip maker, is being forced to raise cash after suffering large losses at its Westinghouse nuclear subsidiary. Analysts believe Toshiba needs to act quickly. The company announced preliminary results for the year that ended in March showing a net loss of 950 billion yen ($8.4 billion yen). Shareholder equity was negative 540 billion yen for the year, and will decline further in the current fiscal year unless a divestment happens according to the company.

A Long Path Through the Legal System is Possible

To raise cash, the company is selling its memory chip division. But, this division has entered into a joint venture agreement with Western Digital and Western Digital is taking steps to ensure it has a say in the deal.

Despite the need for cash, Toshiba seems to be interested in dictating the terms of the deal in a way that benefits the company politically as well as financially.  Toshiba’s preferred bidder appears to be a group backed by the Japanese government. This deal might not be the best terms financially and analysts seem surprised.

As negotiations began, according to Bloomberg, “Western Digital has Toshiba over a barrel. It took the Japanese company to the International Chamber of Commerce’s International Court of Arbitration, and has refused to allow Toshiba to use its shares as collateral to access a much-needed 700 billion yen credit line. Western Digital has since softened its stance, but the point’s been made: There’s not going to be a sale unless Western Digital is invited to the party.”

The latest news seems to be that Western Digital has agreed to match any offer. But, still Toshiba seems to prefer a different bidder. There might even be a very good reason for Toshiba’s reluctance to make a deal with Western Digital.

Antitrust regulators are unlikely to approve Western Digital buying 100% of the division, but the company seems to have the power to block a deal. Western Digital could use that leverage to extract concessions that will boost its operations. However, the companies are not cooperating in this endeavor.

For now, the two companies appear to be locked into a standoff. According to the latest reports, “Toshiba Corp. has resumed blocking Western Digital Corp.’s access to the data servers the two companies share from their micro chip joint venture.” Western Digital will appeal, but a quick resolution appears increasingly unlikely.

The Stock Price Reflects the Standoff

As this saga drags on, traders seem to have decided it is best to pursue other opportunities. The chart below shows that the volatility of the stock has been declining.

In the chart, Bollinger bands are drawn around the price. Bollinger bands provide a visual measure of normal price action. They also have other interesting properties, among them is the ability to visually portray the degree of recent volatility.

The distance between the Bands is measured with an indicator known as the Bollinger BandWidth which is shown at the bottom of the chart. BandWidth has been declining, indicating the distance between the Bands has narrowed as volatility declined.

When volatility declines, we expect the stock price to remain within a relatively narrow range. One option strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.

To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.

In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.

The risks and potential rewards of the strategy are shown in the following diagram which is taken from The Options Industry Council web site.

The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.

Opening an Iron Condor

For Western Digital, the trade can be opened using the following four options contracts:

  • Sell WDC Aug 4 $102 Call at $0.76
  • Buy WDC Aug 4 $104 Call at $0.47
  • Sell WDC Aug 4 $90.50 Put at $1.15
  • Buy WDC Aug 4 $88.50 Put at $0.75

This trade has about two weeks to expiration.

WDC closed at $94.62 on Monday.  The exercise prices of the calls are above that price. The exercise prices of the puts are below that price.

Notice that all of the options expire on the same day. The difference in the exercise prices of the calls or puts is equal to $2. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $200 less the premium received when the trade was opened.

Selling the options will generate $1.91 in credits ($0.76 from the call and $1.15 from the put). Buying the options will result in a debit in the amount of $1.22 ($0.47 for the call and $0.75 for the put). This means opening the trade will result in a credit of $0.69, or $69 for each contract since each contract covers 100 shares. That is before commissions are considered but commissions should be small at a deep discount broker.

The maximum risk on the trade is $1.31, or $131 since each contract covers 100 shares. This is the difference between the strike prices ($200) and the credit to open the trade ($69). Most brokers will require a margin deposit equal to the amount of risk. That means this trade will require just $131 in capital.

The potential reward on the trade ($69) is 52% of the amount risked, a high potential return on investment. The trade will be open for less than two weeks. If a trade like this is entered every two weeks, a small trader could obviously quickly increase the amount of capital in their trading account.

 

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