Since the second half of July 2007 we have experienced increased volatility in worldwide equity markets when the credit crisis emerged to the surface with full force. Equity prices dropped sharply until the middle of August, followed by a strong rebound that lasted until October when the highest level of the S&P 500 index was reached. Since then, prices have been dropping with some attempts to positive corrections. This continued landscape of uncertainty is posing challenges for every style of investor. Being right is already difficult enough, but the cost of being wrong can be so much higher with high levels of volatility in the market.
Every financial landscape however also lends itself to new opportunities and strategies, and in this article I will describe an option strategy that may occasionally work very well in the market environment that we are experiencing these days. I am referring to the possibility of taking a long position in a so called straddle or strangle on an index. For readers who are less familiar with option terminology, a straddle is an option combination of both a call option and a put option where the strike price and maturity date are the same. A strangle is a combination where the strike price of the call option is higher than the strike price of the put option.
The interesting thing about the straddle and strangle is that buying the call option and put option can be constructed in such a way that the combined price of the options is at its lowest point as a function of the underlying value at a given moment, while a direction either way will immediately lead to a value increase of the combination. In other words, the option that increases in value will do this at a faster pace than the value decrease of the other option. This of course sounds almost too good to be true, and there are indeed other elements that may influence the value of the combination in a negative way. The most important ones are the influence of time and volatility. However, in specific circumstances the choice for a straddle or strangle may be very attractive.
Firstly the combination needs a strong movement, without a preference for the direction of the movement, in order to be profitable. A highly volatile environment gives wider swings in either direction and therefore seems to be a natural fit for this option strategy.
Secondly the movement needs to take place rather quickly, when a combination is chosen with a short time until maturity. With these options the passing of time will have a strong negative impact, and because both a call option and a put option are purchased, the element of time works twice as hard to the disadvantage of the strategy. Keeping the position overnight is therefore quite risky, and in my experience option prices also tend to lose more value towards the end of the trading session. A position taken early in the day may have less of a negative impact from the loss of time value in the options.
Thirdly, a long straddle/strangle position is also long volatility. This means that increasing volatility leads to higher prices for both the call option and the put option. Decreasing volatility will lead to lower prices for both options. 
Here is where we see something interesting in current markets. On an intraday basis it can be observed that the VIX is moving in an opposite direction from the S&P 500 index with a very strong negative correlation. If the market goes up, the VIX goes down, if the market goes down the VIX goes up. The same can be observed in the relationship between the VXN and the Nasdaq-100 index. In this strategy we want the implied volatility in option prices to work in our favor, which means that the downward move of the underlying index is the preferred direction. Although I am very skeptical about the ability to predict short term price moves, I do believe an element of reversal to the mean can be observed, and that strong directional moves do run out of steam.
For the described strategy this means that if the investor is patient, there may be the occasional opportunity when this strategy has a higher chance of success than normally could be expected. The time to pay attention is when there has been a strong positive direction at the early stages of the trading day, or a flat start of the trading day after strong increases in the previous trading day. When this situation has occurred, a combination can be selected which is direction neutral, thus ensuring the lowest possible purchase price for the combination, and the highest chance of success.
It must be noted that bid/ask spreads and transaction costs will influence the outcome of this strategy. High underlying values and option series with high volumes and narrow spreads are therefore preferable.
Monday, February 25, 2008
An Options Strategy for Volatile Times
Tuesday, February 19, 2008
Staples proposes acquisition of Corporate Express ordinary shares
Today Staples informed us that they have made a proposal to acquire all ordinary shares of Corporate Express for a price per share of EUR 7.25, representing a total enterprise value of approximately EUR 2.5 billion. The proposal has not been discussed with Corporate Express shareholders and management and the letter to Mr. Ventress, the CEO of Corporate Express, was included in the announcement. From the letter it is clear that Staples has already made some earlier attempts to engage in discussions with Corporate Express, and it seems that Corporate Express has resolutely refused discussions about an acquisition.
I believe the proposal made by Staples is not convincing, and will stand little chance of success. Shareholders of Corporate Express seem to agree with this view when the price climbed to well over EUR 7.50 immediately after the proposal was made public. Staples also informed us that any dividend declared before closing of the transaction will be subtracted from the offer price. Staples explains that they believe the offer is very fair, highlighting the fact that the premium is 67% above the closing price of EUR 4.32 on February 4th, the last day before rumors circulated in the market about a possible offer. The offer is also approximately 33% above the closing price of Corporate Express on February 18th. I believe Staples also understands that this is just the beginning of the acquisition process.
Corporate Express has some big shareholders who will most likely not be impressed with this initial offer, now Staples has finally indicated to see value in a combined company. According to the latest disclosures, bank/ insurance groups Fortis and ING are holding significant shares in the company , while we can also expect investment companies Centaurus and AllianceBernstein to try to squeeze as much as they can out of this opportunity. It is not unlikely that Staples will have to increase its offer to the EUR 8-9 range to convince these large shareholders.
It will also be interesting to see what the reaction of the management of Corporate Express will be. Will they come with the obvious statement that they believe the offer from Staples does not do justice to the true value of Corporate Express, and open the door to negotiations, or will they be more outspoken and maybe bring other alternatives into play.
Will Staples buy Corporate Express?
In the Netherlands there is heated speculation about when Staples (SPLS) will make an offer for Corporate Express (CXP), the Amsterdam based office products supplier, and how high the offer will be.
Last week, the share price climbed more than 40% in a matter of hours based on an article in a Dutch newspaper that Staples had admitted to be in preliminary discussions with Corporate Express about a takeover. Later the same day, Corporate Express came out with a statement that no such discussions are taking place, and the stock gave back a large chunk of the price increase. Still, many investors feel a take over is imminent based on the low valuation of the company, and the problems it has facing the competition, especially in North America where Corporate Express earns more than half of its revenue. Results for 2007 that were mildly positive and a high book value per share should support this scenario.
I feel however there is something wrong with the assumptions for a takeover, and I think the wishful thinking is coming almost entirely from opportunistic Corporate Express shareholders. Of course it would be a wonderful outcome for investors that bought the shares at cheap perceived valuations, and even big opportunistic investors like AllianceBernstein and Centaurus who came to the party too early may favor a rapid and somehow still dignified exit. But the question that puzzles me is why Staples would buy Corporate Express?
Staples is the biggest and strongest company in the sector, with margins and growth rates ahead of its competition. It has consistently delivered increasing returns for shareholders, while using cash flow wisely by buying back shares and investing in expanding the business, both at home and abroad. This model seems to work well, while I believe an acquisition of Corporate Express may turn out to be quite expensive and risky. Sure, they may be buying market share in a highly fragmented home market, while picking up some business in Europe and Australia.
But somehow I believe Staples prefers the current strategy, where it has much more control over its performance and growth rate, where it can stay completely focused with less risk of causing a major disruption in the execution of the strategy through a potentially disappointing integration process. Expanding through new store openings and smaller acquisitions could well be the preferred and more profitable route for Staples’ shareholders.
I hope for shareholders in Corporate Express that I am wrong and that sometime soon in this period of earnings announcements, the much anticipated offer will come, but I will not hold my breath. And neither will the management of Corporate Express if they have been truthful about their preference for going it alone in the execution of their vision for the next few years.