This Takeover Could Deliver a 92% Gain to Investors
Trade summary: A bull call spread in SINA Corporation (Nasdaq: SINA) using the July $40 call option which can be bought for about $2.58 and the July $42.50 call could be sold for about $1.28. This trade would cost $1.30 to open, or $130 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $130. The maximum gain is $120 per contract. That is a potential gain of about 92% based on the amount risked in the trade.
Now, let’s look at the details.
Sina received a buyout bid at a 12% premium from a company controlled by the Beijing online media company’s chairman and CEO. According to The Street,
America’s Economy Could Be In For A Rude Awakening
If you’re worried about why stocks are surging while millions of Americans are out of work and commercial bankruptcies are skyrocketing, I strongly urge you to listen to this message.
Sina received a buyout bid from New Wave, a company controlled by the Beijing online media company’s chairman and CEO.
Under the terms, New Wave would buy the Sina shares it doesn’t already own in a transaction that would value Sina at about $2.68 billion.
The offer comes to $41 a share. That’s a significant premium to the recent price.
New Wave, incorporated in the British Virgin Islands, is controlled by Sina’s chairman and chief executive, Charles Chao.
Sina said the board has formed a special committee to evaluate the proposed deal.
“There can be no assurance that any definitive offer will be made, that any agreement will be entered into, or that this or any other transaction will be approved or consummated,” Sina said in a statement.
Sina Weibo is considered the Chinese version of Twitter.
Last week Indian Prime Minister Narendra Modi deleted China’s Weibo app account, as tension between the two countries over a border dispute escalated.
“According to the requirements of the other party and the relevant community rules, Weibo has now closed the Weibo account, which was previously certified as the “Prime Minister of the Republic of India,” the company said.
The move came after 20 Indian soldiers were killed in a border clash with Chinese troops.”
The stock price after a deal is announced will often be below the deal price as there is a risk the deal will not go through. This provides opportunities for traders who are willing to bear the risk of the deal’s collapse.
In this case, there could be more risk in the mid of some traders since SINA has been in a persistent downtrend.
That may lead to the expectation that investors will challenge the deal as undervaluing the company. This is a risk, but it is a risk that could be managed with an option spread that limits risk to a defined level.
A Specific Trade for SINA
For SINA, the July options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A July $40 call option can be bought for about $2.58 and the July $42.50 call could be sold for about $1.28. This trade would cost $1.30 to open, or $130 since each contract covers 100 shares of stock.
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 $130.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in SINA, the maximum gain is $120 ($42.50- $40= $2.50; 2.50- $1.30 = $1.20). This represents $120 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $130 to open this trade.
That is a potential gain of about 92% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying SINA could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.