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This Troubled Deal Could Be a Gain for Traders

This Troubled Deal Could Be a Gain for Traders

Not all deals go smoothly as Benzinga reported,

“Investors in two large American theme park operators may be in for an interesting ride.

Sell-side analysts are expressing doubts about the wisdom of a reported effort by Six Flags.

 Entertainment Corp (NYSE: SIX) to seek a merger with Cedar Fair, L.P (NYSE: FUN).

Reuters said [recently] that Six Flags is seeking the merger in a bid to expand its size and ticket pricing power, though with the caveat that there’s no certainty the cash-and-stock deal will be reached.

Six Flags, already the world’s largest regional theme park company, saw its shares drop Wednesday after the report, while Cedar Fair stock rose.

“We believe the combination is a stretch,” Wells Fargo analyst Timothy Conder said in response to the report.

KeyBanc Capital Markets’ Brett Andress said: “We tag this at much less than a 50% probability and do see more investor risk vs. reward should this deal happen.”

Both analysts cited perceived “cultural differences” between the two companies, with Andress also failing to find a true geographic effect that would drive additional value to customers.

While Six Flags is the industry giant, Cedar Fair is a bit smaller, with 11 amusement parks, three water parks and four hotels, all in the United States.

Another question for both analysts: why pursue a major M&A move as Six Flags is preparing for the retirement of CEO Jim Reid¬Anderson early next year and undertaking search for a replacement?

Also, the merger strategy in the industry so far has been different. Andress said both Six Flags and Cedar Fair have posted respectable results this year.

That is “one argument against the need for further consolidation, as SIX and FUN remain the acquirers of choice among smaller operators,” the analyst said in a [recent] note.

The news, and the subsequent questions about the news explain the recent volatility in shares of FUN.

FUN daily chart

The longer-term chart shows the extended decline that has unfolded over the past few months.

FUN weekly chart

For the past year, the stock has been forming a broad bottom. Many traders could view the recent rally as an opportunity to exit their positions with a significant gain. This could be especially appealing if the deal is in trouble which could weigh on the stock for weeks or even months.

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.

bear call spread

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 FUN

For FUN, we could sell an October 18 $55 call for about $2.60 and buy an October 18 $60 call for about $0.95. This trade generates a credit of $1.65, 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 $165. The credit received when the trade is opened, $165 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $335. 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 ($165).

This trade in FUN offers a potential return of about 49% 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 FUN is below $55 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 $335 for this trade in FUN.