A few weeks ago, I wrote about UST (UST) as a stock to watch. It was supposed to be purchased by Altria (MO) before year's end for $69.50 a share. UST closed at $64.90 a share on Friday, after Altria announced that the deal may be put off until 2009 because of the deepening credit crisis. Altria will pay UST $300 million if the deal does not close by January 7, 2009. (Shareholder and government approval are required for the purchase agreement to close.)
Let's say you anticipate that the deal will go through as planned, and you buy UST for $65 a share. You can potentially make $5.13 a share, or 7.89% if there's a $0.63 UST dividend payment in December [$69.5 - $65 + $0.63 (possible December dividend) = $5.13 max gain].
If the deal falls apart, UST will most likely drop. The question is how low the stock will go. UST traded between $50 and $56 in the few months leading up to the announcement of the deal. Shortly before Altria's buyout offer, UST traded around $54 a share. It seems likely that if the deal falls apart, UST will drop back to that level, or go lower. So let's say the max loss would be $15 per share minus any dividends received, if UST falls to $50. Unless you're very comfortable with risk and are very confident the deal will go through, buying at $65 is probably not worth it.
There's a safer way to play this, though with a smaller potential reward. The UST Jan '09 65 strike put's last ask on Friday 10/3/08 was $2.45 (it can probably be purchased for a lower price). If you buy UST for $65 a share, and get one Jan '09 65 put for every 100 shares at $2.45, your max gain will be $2.05 a share ($2.68 if there's a $0.63 dividend in December). That's not a bad couple of months' gain in a bear market. Ideally, you can buy the 65 puts below $2.45 and UST shares below 65.
If the deal falls apart before the January 16, 2009 expiration, the most you can lose is your put premium (plus broker commissions), as you'll have the right to sell your shares for $65. If UST pays a dividend in December and you close your position after the ex-date, your loss will be offset by the dividend amount.
This trade is worth it if you're willing to risk $2.45 for a reasonable chance (analysts think there's a 70 to 80% chance the deal will be consummated) to gain at least $2.05 and maybe $2.68 (minus commissions).
Another trade if the deal falls apart (but this one is much riskier and you'll have to watch it very closely) is the following. You buy UST shares and puts as described above. If the deal is canceled, UST starts falling, and you think it'll fall further, you might consider selling your shares for market price and keeping the puts, to sell later for a higher price. This would possibly offset losses more, and may even result in a gain, depending on how early after the deal cancellation you sell and how low the stock drops afterward. (For example, you'll make money if you sell UST at $60 and sell the puts later when the stock drops to $50.)
Yet another possibility is if the deal falls apart, but you think UST is a good long term hold with a decent dividend, sell the put when you think the stock won't fall further and keep your shares.
If you're a speculator who thinks the deal will fail, consider buying puts. Your potential gains will depend on which strike you buy and how low UST goes. Your maximum loss is the put premium.
All of the above assumes that the deal will either fall apart or be closed before January 7, 2009. That is, I assume the deadline won't be extended.
Similar things can be said about Anheuser-Busch (BUD), my other stock to watch, but I don't think it's worth pursuing. The brewer is supposed to be bought by InBev for $70 a share before the end of the year. BUD closed at $65.10 a share on Friday. Its January puts are much more expensive. The deal's price tag is almost five times bigger than Altria's, and at least three of InBev's financiers are experiencing problems.
The market is full of bargains right now, and investors are starting to nibble. But as no one knows where the bottom is and the market can go much lower, consider buying long term puts when you go long a stock. If it's a great company selling for a bargain basement price, the additional cost of a long term at the money put is a reasonable expense. You'll curb your potential gains somewhat (though they will still be potentially unlimited), but you'll know exactly how much you can lose.
If you own stocks that you're thinking of selling because you can't bear the possibility of more losses, see if it's worthwhile to buy puts on them instead.
Disclosure: I hold no positions in the securities mentioned above.