For months, there has been speculation on the fate of Brocade Communications Systems, Inc. (NASDAQ: BRCD). It seems like there is a new alleged deal hitting the wire every week. One week it’s Hewlett-Packard Company (NYSE: HPQ), the next week it’s International Business Machines Corp. (NYSE: IBM).
These rumors have amounted to nothing over the past several months other than causing the stock to gyrate between $5 and $6. However, if I had to guess, I’d say the company will eventually get bought out for somewhere between $6 and $8.
In that scenario, with premiums on the upside somewhat inexpensive, one might think that simply owning BRCD call options is the right play. That seems to be what major broker dealers and institutional houses are doing. Open call interest on the $6 strike is massive in both January and April.
What is my objection to this play? NOTHING HAS HAPPENED.
December open interest is over 40,000 contracts, and these options are likely to expire worthless. Thus, the owners will lose the entire premium. So those traders rolling out to January aren’t really hedging, they are simply doubling down. And they should be careful in that process as rolling can significantly run up the costs of a play.
For instance, suppose in October, I thought BRCD was going to get bought out in November. In a bullish play I buy the November 6 calls for 20 cents, and then nothing happens.
Thinking that the buyout will still happen, I roll the November calls, selling them at 3 cents, and I buy the December 6 calls for 20 cents. My cost on those calls is now 37 cents (- 0.20 + 0.03 – 0.20), and then nothing happens again.
So I roll out one more time, selling the December calls for 4 cents and buying the January 6 calls for 18 cents. Now my cost for the bullish call play is 51 cents (- 0.20 + 0.03 – 0.20 + 0.04 – 0.18). You can see how this type of play could turn into a bit of a problem.
My solution: Cut down on the number of call contracts, and sell put contracts creating a risk reversal.
Over the past three months, as the rumors have circulated, the lowest this stock touched was about $4.90. Even before the rumors began, the absolute low was $4.70. I’ll play it safe and say BRCD could go to $4.50. That is my downside risk. On the upside, the stock could get bought out at up to $8, but let’s just say $7 to be safe.
If I sell the BRCD April 5 Puts and buy the BRCD April 6 Calls, my net cost on the trade will be 0. If the buyout deal happens, I would make $100 per spread. On the flip side, if BRCD bottoms out, I would only be out $50.
As I have stated in the past, I like trades that are in my favor. Over the life of the trade, when BRCD rallies I may be able to sell out of this trade for a profit even if a deal never happens.
There are other more sophisticated risk reversal combos that might even be better. The point of this piece is to show you that by not following the pack, a trader can manage to weather the waves of a stock like BRCD, and avoid ringing up commissions and trading costs.