Monday, May 5, 2008


As I'm sure you already know, internet giant Yahoo! this weekend rejected Microsoft's take-over offer after they upped their bid by two bucks to $33/share. The suits in charge at Yahoo! felt that their company was worth at least $4/share more and felt slighted by the paltry increase. Of course the question on everyone's minds is not if Microsoft will still pursue the merger but if any sort of merger will be happening with either of the companies. Both sides of this question are currently being bandied about in the financial media and I'm not going to regurgitate the arguments here.

What I do want to focus on is if there's a possible play in all of this. In my blog on February 1st when the proposed merger was first announced, I suggested buying Yahoo stock at the going price of around $28/share and writing the April 30 covered call (trading then in the $1.50-$1.60 range) against it. That call would have expired worthless on Friday, April 18th and if you had again written the May 30 call in the $0.80 - $1.00 range on the following Monday, you would have at least cushioned yourself against today's 15% drop in Yahoo! share price. Had you written these calls, your cost basis would have been lowered to around $25.50 thus limiting today's loss to about 5% instead of 15%. This is one good reason to use covered calls on controversial take-over targets.

This play is a no-brainer in retrospect as hindsight is always 20/20. But is there still a way to profit from this situation? It's anyone's guess but the word on the street is that some sort of merger is probably in the offing since they're highly skeptical that Yahoo! will be able to live up to its financial targets. Perhaps in the short term this could put downward pressure on Yahoo! shares, but if the price falls too far, the board can surely expect a bunch of shareholder lawsuits (some are already suing the company). Whether or not Microsoft steps back into the picture is immaterial; what really matters is that someone will and probably sooner rather than later.

If I believe this (and I do), here's how I would play it. If I'm still short the May 30 calls, I'd buy them back today for ten cents. I'd wait a day or two and if the stock doesn't tank, I'd either write the July 25 calls or buy them outright. (These calls are trading today for around $2/contract.) In the event that a merger is announced between now and the middle of July, the share price will go up and at worst my stock will be called away at $25/share. Since my current cost basis is $25.50/share means that I'll have pocketed an extra $1.50/share which translates into a 5-6% return. If I buy the calls instead of selling them will give me a much larger return. Even if Yahoo! accepts a price that is close to Microsoft's original bid of $31/share means that at on or before expiration, my calls will be worth at least $6/contract giving me a minimum 200% return on my investment. (($6 final price - $2 cost)/$2 cost basis x 100%). I like that type of return. The only possible wrench in the gears is that Yahoo!s share price falls substantially but I really don't think that the Yahoo! shareholders are going to let that happen.

Actually, Mister Softee might have done us a favor by letting us turn a Ya-Boo! into a Ya-Hooooo!!!!

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