Yahoo! Inc. (NASDAQ:YHOO) & Verizon Communications Inc. (NYSE:VZ) Deal

The rumors are out this morning that Verizon Communications Inc. (NYSE:VZ) is close to an agreement to buy Yahoo! Inc. (NASDAQ:YHOO). One intriguing way to play this possibility is with a long-dated Yahoo buy-write.

Long-dated buy-writes, typically involving buying shares and selling call options with a year or more to expiration, can be effective ways to speculate on takeovers. When deals are made for cash, virtually all the time value of the option disappears, since options are about volatility and cash, by definition, has none. Thus, depending on the terms of the deal, it’s actually possible to make money on both the long-stock and short-call components, or at least to make substantially more on the stock side than you lose on the option.

The added benefit is that the call premium effectively reduces the cost of buying the shares, so that if no deal happens, you at least have some cushion against the likely stock decline.

Buy Write Strategy

Consider Yahoo’s calls struck at $40, expiring in January of 2018, 18 months from now.   At yesterday’s close, you could have sold these calls at $4.30 while buying shares for $38.85, a net cost of $34.55. Assuming a cash deal of $40 or greater means a return of nearly 16% over 18 months or less, or slightly over 10% annualized. What’s more, if the deal should close, for cash, earlier than the options expire, the shortened lifespan of the options increases the annualized return.

If Verizon pays stock for part of all of Yahoo, the trade would turn into a buy-write on Verizon. But Verizon’s options trade at substantially lower implied volatilities than Yahoo’s even though Yahoo’s long-dated options already are trying to discount the effect of a deal. Plus, as a Verizon shareholder, you would receive a healthy 4% dividend.

The arrow in the chart below points to the effective cost of Yahoo shares as of Thursday’s close using this strategy.