Monday, May 19, 2014

* DIRECTV (DTV) - Takeover, Sort Of. How Equity & Option Markets Totally Disagree on Probability of Takeover Happening.

DTV is trading $84.99, down 1.4% with IV30™ imploding down 57.2%. The Symbol Summary is included below.

Provided by Livevol

So the headline news is this:
AT&T agreed Sunday to buy DirecTV for about $48.5 billion []  In the deal, AT&T would pay DirecTV shareholders $95 per share.

Source: USA Today via Yahoo! Finance: AT&T buys DirecTV for $48.5 billion

So why is DTV stock down today?  Well, there's a little red herring called the National Football League.  Yeah, if DTV can't secure the NFL renewal deal, then AT&T shareholders can vote down this buyout.  So, what has in fact transpired is that the NFL now holds the reigns on a ~$67.5B merger deal (including DTV debt).  How do you think the NFL's negotiation strength has changed in the last three days?

Here's the interesting part of this story, the equity market and the option market show two different versions of the world.

Let's start with the Charts Tab (two-years) is below. The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).

Provided by Livevol

Focus on the top portion, the stock price.  DTV stock had risen from ~$76 to ~$89 in the last several days based on this imminent takeover.  The stock is up from a two-year low of ~ $43, but that's semi-independent of this deal.  Just keep that $43 level in mind for later.

Now that the deal has been finalized.. ya know except for that one "thing," the stock is down to the $85 level. How nice for us, that math is easy, it's $10 below the deal price.

There is going to be wild disagreement with I'm about to write, but that's OK, I'm just a guy.  Here we go: I believe, in rough (very rough) estimation, the equity market reflects ~50% chance of the deal going through.

How the hell did I come up with 50%.  Try this:

DTV steady price: ~$75 (end of March price before takeover craze)
DTV takeover price: $95
DTV current price: $85

Takeover premium: $95 - $75 = $20.
Current realized premium: $10.
$10/$20 = 50%.

Yep, that's where I got it.  Any the option market?... Not. Even. Close.

Let's turn to the IV30™ chart in isolation, below.

Provided by Livevol

The implied volatility (future looking risk) has absolutely collapsed on the takeover news.  That's actually normal and expected.  But, it's "normal" and "expected" if the equity market reflects a "normal" and "expected" result of a completed takeover.

Check out the next several images to see how differently the option market prices this event.

The Skew Tab snap (below) illustrates the vols by strike by month.

Provided by Livevol

OK, so the skew is "normal" shaped, with the downside puts priced higher than the upside calls.  That makes sense, especially since it appears $95 is sort of the cap for DTV stock.  Check out the actual levels on the vertical axis; we're looking at ~11% volatility.

How does that compare to pre-takeover news?

Let's turn to the DTV skew chart exactly two-months ago.

Provided by Livevol

We can see the upside calls were priced to ~23% vol (using Sep options here rather than Dec options now as a proxy).  So, the risk in the upside price has collapsed.

But, look a little more closely.  the vol in the $75 strike puts back in March was ~25%.  Today, the vol in that strike is ~14%.


To read more about skew, what is and why it exists you can click the title below:
Understanding Option Skew -- What it is and Why it Exists.

Finally, the Options Tab is included below.

Provided by Livevol

Check out, for example, the $80 strike puts.  Those are worth ~ $1.90.  On 3-19-2014 those puts were worth $7.80, but... the stock was $75.39.  Taking out parity, those puts have ~$3.20 in extrinsic value.

So, we're comparing a $3.20 price to a $1.90 price.  In English, the option market has priced in a much higher probability that this deal will go through (the puts are dead).

The upside is essentially nil over $95 (the $97.5 strikes have no bid).  With the stock $10 lower on 3-19-2104, the $100 strike calls were worth $0.30.  Whoa... So now, the upside is dead too (to the option market).

The equity market is pricing a coin flip(ish) outcome for this takeover, while the option market is pricing in a much higher probability.

My opinion: i think AT&T has given way too much power to the NFL and this thing is closer to the equity market probability (coin flip) than the option market.  In English, options look cheap (but I am not buying options and I am not recommending anything).

The Dec options (using the $85 strike) reflect a price range of [$77.50, $92.50] by Dec expiration.

  • If you believe the stock will be outside that range on expiry or any date before then, then you think the volatility is too low.
  • If you believe that range is too wide, and that the stock will definitively be in that range on expiration, then you think volatility is too high.
  • If you're not sure, and can make an argument for either case, then you think volatility is priced just about right.

This is trade analysis, not a recommendation.

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  1. Ophir - Very nice post. Though we can quibble about "details", you are showing a clear path to thinking like a trader, which is rare in our industry and far more important than the "details". Keep up the great posts! Al