Sean Alicandri, a sophisticated investor who is both
willing and able to take risk, has just noticed that Mid-
West Airlines has become the target of a hostile takeover.
Prior to the announcement of the offer to purchase the
stock for $72 a share, the stock had been selling for $59.
Immediately after the offer, the offer the stock rose to
$75, a premium over the offer price. Such premiums are
often indicative that investors expect a higher price could
occur if a bidding was erupts for the company or if
management buyout of the firm. Of course, if neither of
these scenarios occurs, the price of the stock could fall
back to the $72 offer price. In addition, if the offer
were to be withdrawn or defeated by management, the price
of the stock could fall below the original stock price.

Alicandri has no reason to anticipate that any of these
possibilities will be the final outcome, but the realizes
that the price of the stock will not remain at $75. If a
bidding war erupts, the price could easily exceed$100.
Conversely, if the takeover fails, he expects the price to
decline below $55 a share, since he previously believed
that the price of the stock was overvalued at $59. With
such uncertainty, Alicandri does not want to own the stock
but is intrigued with the possibility of earning a profit
from a price movement that he is certain must occur.

Currently there are several three months put and all
options traded on the stock. Their strike and market
prices are as follows:


Strike Price Market Price of Call Market Price of Put
$50 $26.00 $0.125
55 21.50 0.50
60 17.00 1.00
65 13.25 1.75
70 8.00 3.50
75 4.25 6.00
80 1.00 9.75

Alicandri decides the best strategy is to purchase both a
put and a call option (to establish a straddle). Deciding
on a strategy is one thing; determining the best way to
execute it is quite another. For example, he could buy the
options with the extreme strike price (i.e. the call at $80
and the put at $50). Or he could buy the options with the
strike price closest to the original $72 offer price (i.e.
buy the put and the call at $70).
To help determine the potential profits and losses from
various positions, Alicandri developed profit profiles at
various stock prices by filling in the following chart for
each position:

Price of the stock Intrinsic Value of the Call
Profit on the Call Intrinsic Value of the Put
Profit on the Put Net Profit
$50
55
60
65
70
75
80
85

To limit the number of calculations, he decided to make
three comparisons: (1) the purchase of two inexpensive
options-buy the call with the $80 strike price and the put
with the $60 strike price, (2) the purchase of the options
with the $70 strike price, and (3) the purchase of the
options with the price closest to the original stock price
(i.e., the options with the $60 strike price).



Construct Alicandri’s profit profiles and answer the
following questions.

1) Which strategy works best if a bidding war erupts?
2) Which strategy works best if the hostile takeover
is defeated?
3) Which strategy works best if the original offer
price becomes the final price?
4) Which of the three positions produces the worst
result and under what condition does it occur?
5) If you were Alipcandri’s financial advisor, which
strategy would you advise he establish? Or would you argue
that he not speculate on this takeover?