This is a Guest Blog from CNBC Contributor Brian Stutland.
Yesterday, shares of Dell jumped 13% on reports that the company was in talks with several private equity firms about going private. This morning, Jefferies raised their price target on the stock to $13 "to reflect the possibility of" a leveraged buyout.
Option trading on the stock was decidedly bullish, with 3.8 calls trading for every put on nearly twice the average daily volume. One of the biggest trades of the day was the purchase of 2,500 January 2014 15-strike calls for $0.50 each, which was done with the stock at $12.36.
This is a bullish bet that the stock will reach at least $15.50 by this time next year.
(Read More: Dell Buyout Has '50-50' Chance: Wilbur Ross)
As option traders scrambled to buy out-of-the-money options on the buyout rumors, implied volatility in the stock skyrocketed. In other words, options have become quite a bit more expensive, as a result of the heightened uncertainty surrounding the stock. While this did not dissuade this trader from buying long-dated deep out-of-the-money calls, I believe it is very important for traders to take a step back here and analyze the situation before joining the call-buying frenzy.
A key metric that private equity firms look at when analyzing a deal is "enterprise value." Enterprise value is basically the market cap of the stock, plus outstanding debt, minus cash and investments. Private equity firms like to buy companies at a price below enterprise value, unless they believe they can unlock major synergies through the acquisition that will create new value that the market is not currently pricing in. Dell's current enterprise value is $12.54 per share, which is below yesterday's high. This does not mean that someone will not buy Dell above enterprise value— but it does make it less likely that a private equity firm will pay a big premium over yesterday's closing price.
Another headwind facing a potential buyout of the company is Michael Dell's personal stake in the stock. He is currently the company's largest shareholder, with a roughly $4.5 billion position. It is unlikely that a private equity firm would want to be a minority shareholder in the company, and yet there are few firms that would be able or willing to put up over $4.5 billion to become the largest shareholder. Again, this does not mean that a deal cannot be done— but it does mean that a deal will require serious financing and will not appear overnight.
(Read More: Dell Buyout Not Happening: Sacconaghi)
The key to playing this stock will be to keep risk small and reward high. Following this trader and buying out-of-the-money calls that expire in a year is probably a good way to go if you want to step into the stock today. Long-dated options are less sensitive to initial spikes in volatility, which means that they will have more reasonable premiums than the short-dated options. They also have less time decay, and give the trade time to work.
After such a big one-day run on nothing but a rumor, I would think the stock is due for a pullback sooner rather than later, as traders look to take some profit off the table. If you want to buy calls on the stock, I would wait to do it on a dip after the initial frenzy has abated. Also, if you buy long-dated calls, selling further-out-of-the-money calls and maybe even going a little longer dated with that call sale is almost needed, because if a private deal is reached, the stock pins to the takeout price and all volatility being priced into options goes to near zero. After all, once all the news has already happened, why would you continue to buy calls? That's why calls that are far out of the money end up being worthless.
All in all, buying something like the January 2014 15-strike call is a good way to take a shot on this stock while minimizing cash outlay.
Disclosures: I have not entered into a position in Dell in years, but should I see a pullback, I might get in as described above.
Brian Stutland is Managing Member of Stutland Equities and a contributor to CNBC's "Options Action."
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