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How to Trade Rumors of Takeovers

Thursday, July 7th, 2011

Sometimes someone else says it as well as I think I can.  Today I would like to pass on what Steve Sears at Barrons.com wrote about trading on rumors of a takeover.  I agree with him completely.  Bottom line, I believe the answer is to do nothing about them.

“Everyone loves the idea of owning a stock, especially call options, on a company that might be taken over at a hefty premium. But the options market inflates with at least 10 false takeover rumors for every real deal. Individual investors need to be careful to avoid getting fleeced for reasons that have far more to do with market realities than risk-aversion.

The best bet for most investors is ignoring takeover rumors. If you own options on a takeover stock, sell them, and book the profits. How much better can it get? When rumors become facts, or fail to become facts, implied volatility declines.

If you must trade takeover rumors, buy inexpensive out-of-the-money calls that expire in three months or less. If the deal emerges, you’ll make money, and not lose much if nothing happens.

To be sure, institutional investors who own dud stocks, or who want to create profits where none exist, spread rumors to drive options and stock prices higher to attract unsophisticated investors.

The game works like this: traders buy enough out-of-the-money call options to be spotted by unusual-trading volume screens that monitor the options markets. Inevitably, a reporter, or one of the market-trading subscription Websites notes the unusual trading, and deal speculation sweeps the market. Takeover talk attracts greedy investors who pay top prices for call options, which creates selling opportunities for those who started the rumor.

No one has statistics on how many takeover rumors fail to materialize, but when you feel eager to get a piece of the action, think of the rows of grizzled gamblers hunched over Las Vegas slot machines. They have no special knowledge. They have no special skills. They just hope to get lucky. The same rubric applies to most takeover traders.

“Losers,” as seasoned traders like to say, “always come back to Vegas.”

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