Clever traders use call warrants to profit from those M&A rumours

WITH the exception of shot gun weddings in the banking sector, mergers and acquisitions (M&amp;A) activity practically died a death during the financial crisis. But recently there has been a slew of rumoured buyout offers such as Kraft&rsquo;s bid for UK confectionary giant Cadbury.<br /><br />Indeed, Credit Suisse analyst Richard Kersley believes that the Kraft bid will be the first of many buyout attempts by companies over the next few months, and said that key US indicators suggest M&amp;A activity is set to surge &ldquo;right about now&rdquo;.<br /><br />He also noted that banks, building materials and insurance will see buyouts, encouraged by the good values of rivals whose prices have collapsed in the global financial crisis.<br /><br />Traders love acquisitions activity because rumour of a bid &ndash; or indeed a bid itself &ndash; can send the price of the target company soaring. Bids are normally made at a premium to the target&rsquo;s current share price in order to sweeten the offer and induce shareholders to accept. For example, Kraft initially offered 745p a share for Cadbury, made up of 300p cash and 0.2589 new Kraft shares. Cadbury had been trading at 568p a share prior to the buyout bid. The share price has since risen to about 800p as traders priced in the offer.<br /><br />Spread betting and contracts for difference (CFDs) have typically been seen as the best means for individual traders to take advantage of potential acquisitions activity, because you can establish a position at the current price in anticipation of the shares soaring on the back of an attractive bid. However, traders using spread bets and CFDs should bear in mind that an expected offer &ndash; even if it has been rumoured in the markets for some time &ndash; can take a while to materialise. Rolling over your position until this happens, perhaps several months down the line, can be very expensive in terms of overnight financing charges.<br /><br />This is where covered warrants can prove very useful. Traders looking to use them to take advantage of acquisition activity would look to buy a call covered warrant &ndash; the right but not the obligation to buy at a set price and date &ndash; on the target company. There are no overnight financing costs (although the warrant will experience a deterioration in time value the closer it comes to expiry) and your maximum losses are fixed with warrants, unlike the unlimited potential losses possible with spread bets and CFDs.<br /><br /><strong>GOOD PREMIUMS</strong><br />Call warrants have been known to jump in value very sharply on the news of a takeover bid with a good premium, so they are ideal for short-term traders looking to back a target stock. You would want to choose a call covered warrant with a reasonable amount of time left to maturity so that the jump with an price is not seriously offset by the deterioration in time value.<br /><br />Longer-dated covered warrants are ideal for traders who want to take a position in an underlying stock and wait for a bid to develop without having to tie up too much of your capital.<br /><br />The strike price that you choose would depend on how much of a premium you think will be offered for the stock &ndash; bear in mind that if you waiting for a bid to develop other factors could shift the share price in the meantime, undermining the strength of a warrant position.<br /><br />However, before you start buying covered warrants in potential takeover stocks, there is a danger of buying call covered warrants that are too far out of the money &ndash; that is, the current price of the stock is significantly below the call warrant&rsquo;s strike price. If a cash bid is indeed received but it is still below the strike price, then your position could expire worthless and you will have lost your initial investment.<br /><br />With Credit Suisse&rsquo;s Kersley mentioning gas major BG Group, housebuilders Bovis and Redrow, and both Punch Taverns and Whitbread as potential takeover targets (among many others), covered warrants traders looking to make the most of the increased M&amp;A activity, have more than enough opportunities on offer.