Lessons to Learn from Potash (POT)

Potash Corp. POT spiked about $31 higher today after the company revealed it received an unsolicited, $130-per-share offer from BHP Billiton. The board of POT unanimously rejected this offer as “grossly inadequate.”

POT closed yesterday (Monday) at $112.15. Why is the stock up so dramatically if the board rejected the bid? The market likely thinks BHP or someone else may bid higher than $130 for the company. In other words, POT is now “in play.” The board did not say they would never sell; they simply said $130 per share was too low.

What did this mean for Potash options?

Short-Dated Calls

First of all, short-dated calls rose tremendously in today’s session. The August $120 calls, expiring in a matter of days, were up nearly $23 at the close. For traders who do not cover their short out-of-the-money “teenys” and expect to just let them expire, this is an example of when that logic can really hurt. Those calls could have been bought back for less than 50 cents, and now they are worth $22.9. Obviously, this sort of scenario does not happen often, but when it does, it can be dramatic.

1 X 2 Ratio Call Spreads

Another group of traders who were affected were those traders who bought call ratio spreads. Investors who targeted a small rally by selling twice as many 125 calls for every purchased 115 would be down more than $7 on the trade today from the previous day. The move in POT was just too big to the upside.

Long-Dated Options

Finally, because the market thinks the potential deal might be all cash or a large portion of cash, long-dated volatility has declined tremendously. POT stock was up about $31 today, and the January 2012 165-strike calls were actually lower on the day at one point. How is that possible?

Well, the volatility of cash is zero. If a company is purchased for cash, the options go away and are settled into cash. For example, if the deal was for $164 cash, after closing, the $165 calls would be worth zero. There would be some value to them between the announcement and the deal closing because the deal could fall apart or another player could make a higher bid. However, if it played out until closing, all the strikes above the deal price would go out worth 0, well before expiration. All of the additional time value would be worthless!

Traders have to adjust for the heightened risk that these options might be affected by this. It is usually most pronounced in the out-of-the-money calls.

Obviously, there were a lot of people who made a lot of money in this stock today. They were long stock, long shorter-dated calls, etc. Announcements like this are a good example for traders to understand what may happen in these scenarios. Even if you do not have a position on in POT, every trader should understand these special situations, as they might be involved with a stock that could become a takeover candidate in the future.

Photo Credit: Andreia Bohner

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