Yahoo option traders hit as Microsoft drops bid

CHICAGO (Reuters) - Microsoft Corp's decision to walk away from a proposal to buy Yahoo Inc caught options traders off guard on Monday, with many of them positioning for a deal to get done.

But die-hards are refusing to give up the ghost and have replaced their near-term bets with options that expire in the summer months on hopes that Microsoft could re-approach Yahoo, traders and analysts said.

After three months of public negotiations, Microsoft withdrew a sweetened $33-per-share offer on Saturday after talks collapsed, with Yahoo demanding $37 per share.

"The takeover dream has not died yet," said William Lefkowitz, options strategist at brokerage firm Finance Investments, pointing to the buying of June calls and the fact that Yahoo shares bounced off their opening lows on Monday, closing 15 percent lower on the day at $24.37.

"Traders are also talking about a potential alliance with Google or Time Warner," said Pete Najarian, co-founder of Web information site optionmonster.com.

Particularly notable were the June and July calls, allowing investors to buy Yahoo shares for between $27.50 and $32.50.

Reports late last week of Microsoft and Yahoo stepping up their efforts to strike a deal had boosted options activity.

"There was a sense that the deal would go through, albeit closer to Microsoft's original $31-per-share offer than very much higher," said Rebecca Engmann Darst, equity options analyst at Interactive Brokers Group.

That created a great deal of speculative activity in the May $30 calls, which were by far the most active contract on Friday with roughly 160,000 lots changed hands, data from option analytics firm Trade Alert showed.

"Trading was particularly heavy in that strike during the last hour of trading (on Friday) as most people thought that the Microsoft bid for Yahoo was a done deal," said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim.

A lot of volume seemed to be made up of spreads as traders bought May $30 calls and sold the higher $32.50 strikes. While traders wanted the May $30 calls, the spread trade suggested they did not expect a sweetened bid or Yahoo shares to go much higher than $32.50. Yahoo shares closed at $28.67 on Friday.

"Anybody betting on the deal closing took a hit," said Henry Schwartz, president of Trade Alert.

A lot of Yahoo option traders also played it safe by accumulating puts, giving them the right to sell the stock.

"For the past week, the contracts outstanding on the put side in Yahoo was growing, indicating that traders were uneasy about the deal," said Randy Frederick, director of derivatives at Charles Schwab & Co Inc.

"The amount of open interest in the May $25 put strike suggests that savvy traders may have hedged their bets on Friday on the deal falling apart," Trade Alert's Schwartz said.

Option traders are still looking for more price risk to Yahoo shares over the next 30 days. In all, roughly 958,000 calls and 400,000 puts changed hands in Yahoo on Monday, five times the normal volume, according to Trade Alert.

With calls far outpacing puts, Darst noted traders did not appear to think Yahoo shares would plunge into the mid-teens, though plenty of speculative two-way traffic was seen at strikes $22.50 and $25 in the May contract.

Traders were also selling May $30 calls, implying Microsoft's bid was as good as it would get for Yahoo shares, Darst said. There was also buying interest in June $22.50 calls, which traded for as much as $3.35 cents each.

"If another bid happens, it would occur after May expiration," Schwab's Frederick said. "There are some people who believe that Yahoo shares will flounder for a while and then Microsoft will make a second bid at a later time."

(Editing by Braden Reddall)