Bet on Activism with Backspreads

Activist hedge funds have been a driving force in the markets for some time now. They build up sizable stakes in troubled companies and work to unlock value through a series of initiatives, ranging from share buybacks to outright asset auctions. The success of these campaigns depends largely on the board of directors and the number of shareholders supporting their initiatives. As a result, the profitability of following these investors is rather hard to predict. However, there is one constant: volatility.

Activist shareholders often attempt to unlock value through dramatic transactions that will jump the share price substantially. As a result, stocks that are targeted by activists typically jump as soon as they notify the public that they have acquired a substantial stake (via a Schedule 13D filing with the SEC). If they are successful in unlocking value, the stocks generally soar even further during the next few months. However, if the measures fail the stocks often drop back down to their previous level or lower.

There is a great strategy that can be used to capitalize on volatility in either direction with a favor to the upside – since many popular activists don’t lose more than they make! The strategy is known as a backspread and it involves purchasing two out-of-the-money calls and selling one in-the-money call. The result is a position whereby you are left with a small credit. If the stock drops substantially (in the event of an unsuccessful campaign) you will keep this premium and the options will cancel out. However, if the stock soars, you are able to realize unlimited potential upside from the additional call option!

The maximum loss for this position is limited by the price of the options since they cancel out. Investors will lose money if there are delays in the process that keeps the fate of shares uncertain. However, this situation is minimized in activist situations since stocks tend to trend down after the initial move upwards if nothing happens. In the end, this is a great strategy for those looking to play activist situations or technical breakouts (another useful strategy for this type of options strategy).

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