This Deal Might Be Too Expensive
Companies meet with investment bankers and try to find the ideal price for a deal. They might negotiate for weeks, or even months. Bankers will pore over financial statements and review similar deals. They are experts in this process.
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Yet, the moment the results of their work is announced, traders review their work and determine whether or not they agree. If they disagree, the stock price moves sharply. In the case of a recent deal, they seem to believe the deal is priced relatively far from fair value.
KORS Pays Up for Versace
According to Barron’s, Michael Kors Holdings Ltd.(NYSE: KORS) is close to a deal to buy Italian fashion house Gianni Versace SpA for about 2 billion euros ($2.35 billion. The deal would combine one of the most famous names in high fashion with a giant well known for affordable luxury.
A deal would give Michael Kors, whose best-known product is a handbag priced at less than $500, a sought-after foothold in high fashion. Versace handbags start at $1,500. A Versace velvet dress emblazoned with a leopard sells for more than $2,500.
Versace was famously founded in 1978 by Gianni Versace and “the label quickly became famous for his sexually charged designs, featuring colorful prints and daring cuts.”
But, the brand has also been associated with tragedy. In 1997, Versace was gunned down outside his Miami Beach mansion by a serial killer, who targeted his victims randomly. His sister, Donatella Versace, became creative director after his death.
Donatella Versace then struggled with drug abuse and checked herself into a rehabilitation program in 2004. She has since recovered and overseen operations at the company. Now, it isn’t clear of the family will remain as minority shareholders in the business, or even if Donatella Versace would stay on as creative director, if a deal is consummated.
Private-equity giant Blackstone Group, which owns 20% of Versace, is planning to sell its stake in the business as part of the deal, Barron’s noted.
Is KORS Buying Problems?
Over the past few years, Versace has struggled to grow sales. Experts note the brand has been overshadowed by Italian rival Gucci, which has become one of the fashion industry’s fastest-growing brands.
Traders immediately question the value of the deal as they sold. The stock price fell on the news.
Traders are now forced to address whether or not KORS has put in a long term top. The weekly chart shows that is a possibility.
A Trading Strategy to Benefit from Potential Weakness
The prospects of a further short-term gains in KORS seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for KORS
The bearish outlook for KORS, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the October 19 $70 put can be bought for about $4.40 and the October 19 $65 put can be sold for about $1.50. This trade will cost about $2.90 to enter, or $290 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $290. This loss would be experienced if KORS is above $70 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade in KORS is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in KORS, the maximum gain is $2.10 ($70 – $65 = $5; $5 – $2.90 = $2.10). This represents $210 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $290 to open this trade.
That is a potential gain of about 72% of the amount risked in the trade. This trade delivers the maximum gain if KORS closes below $65 on October 19 when the options expire.
Put 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 $290 for this trade in KORS.