The Importance of Timing in Options Trading

The obvious difference between buying an actual share of stock and an option contract is that a share of a company is held in hand, while an option contract is the right but not the obligation to buy or sell shares in the future. This makes timing a very important factor in creating and executing an option trade. The very basics for those unfamiliar can be found in this post regarding The Basics of Options Contracts.

I recently experienced the negative effects of mistiming an option trade first hand when I attempted to profit form the United Airlines and Continental Airlines merger. At first, United started talks with US Airways (good thing I didn't buy into US Airways then) in what turned out to be a ploy to get United to come back to the table for merger talks after failed attempts several years ago. Finally, one Friday morning it was announced that the United and Continental boards would meet over the weekend to finalize the merger. It looked like United would be the effective "buyer", and Continental shareholders would come out of the deal with an extra $3 billion in cash from United, plus the prospect of future synergies and expanded market share from the combined company.

Whenever a merger is about to take place and/or does go through, the company seen as the "buyer" historically sees their share price decline (because shareholders see a large amount of their cash going into a deal that may or may not prove profitable) while shares of the company being acquired in the merger usually go up (because a large amount of cash, or stock, or both, is coming in). Betting on mergers in the form of going long the company being acquired and short the buying company is known as risk arbitrage, and is practiced on the trading floors of every major investment bank and several hedge funds.

I attempted to take the long position on the acquired company, Continental (CAL) by purchasing a call option as follows:

  4/30/2010 11:33:14 AM
BUY  +1CAL100MAY 10     24 CALL      $0.76$0.76

I paid $76 for the option (each option contract represents 100 shares, so you need to multiply the share price you see above by 100) plus a $2.95 thinkorswim commission, and a .014 cents fee to the SEC for the trade (this fee is charged on every type of trade to help support the activities of the SEC). I needed CAL to go above $24 and some change in order to make a profit and cover my fees.

Once the merger was announced Monday, CAL shares did appreciate, but did not go anywhere close to reaching $24 per share. I had made the mistake of not realizing that the market had already priced in the merger into both United and Continental shares on the belief the merger would definitely happen, with the finalization meetings over the weekend not doing much to take CAL further up. A few days following the announcement, fears of the Euro debt crisis (Read more about The Irrationality of Markets) initiated a sell off in the market that rendered my option even more out-of-the money.

All this means I mis-timed my trade. If I had bought the contract earlier before the merger had been priced in, I could have made a decent profit. I ended up selling my option to close (meaning selling my position in the option contract to someone else) for $7 minus associated fees in order to slightly offset some of my losses.

One thing to note for thinkorswim users: On their web based platform, selling to close unfortunately looks exactly the same as selling to open (which means writing an option contract and collecting a premium). I found this out after contacting their customer service department, which was a fantastic experience. I highly recommend thinkorswim to anyone considering option trading. Do let me know if you make an account!