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(Reuters) - Many options traders who had taken bets on a successful buyout of Time Warner Inc (TWX.N) by Rupert Murdoch's Twenty-First Century Fox Inc (FOXA.O) are facing a grim lesson in the risks of betting on deals.
Murdoch pulled the $80 billion offer after the close of trading on Tuesday, saying Time Warner management had refused to engage in discussions. He also cited the sharp drop in Fox's share price since the proposal last month, saying it "makes the transaction unattractive to Fox shareholders."
Time Warner shares dove about 10 percent to $76.80 from $85.19 following news of the offer's withdrawal, while Fox's stock gained around 9 percent.
Expectations that Fox would increase its bid to at least $90 a share and even above $100 a share had prompted traders and investors to put down a series of bets.
There are more than 25,000 out-of-the-money call option contracts expiring in mid-October that anticipate Time Warner to close at a price anywhere between $90 a share and $105 a share.
Each call or put option contract represents the right to buy or sell 100 shares at a particular price.
There are more than 12,700 outstanding contracts that bet on Time Warner shares to close above $92.50 by mid-October. Just after the Fox bid, those options surged to trade at a peak of $3.09 each.
Since then hopes of a deal had diminished as Time Warner made it clear it didn't want to talk to Fox about a deal.
The mid-October options closed Tuesday at $1.20 each and are expected to fall sharply when the market opens on Wednesday. If a trader had bought all those contracts at the peak, the cost would have been about $3.92 million. They are now worth about $1.52 million and the value is expected to drop much further.
Randy Frederick, managing director of trading and derivatives with the Schwab Center for Financial Research, in Austin, Texas, said that if Time Warner shares do indeed open about $10 lower on Wednesday, the mid-October options would likely see their value drop to about 10 or 11 cents.
“You’re looking at a 90 percent drop in value,” he said. “Unless they got those positions before the announcement, they probably paid a lot and were looking to get a small gain.”
Indeed, that looks like a distinct possibility if Tuesday's after hours swoon in Time Warner shares continues into trading on Wednesday.
There are also plenty of positions expiring in August and September that are in danger of turning into losers. More than 17,000 call options contracts in Time Warner that expect a close above $85 currently trade at $1.65 each option - and they expire next week. At their peak, those contracts would have cost $6.89 million and are now worth about $2.81 million.
Notably, trading on Time Warner options on Tuesday was dominated by put buying, according to J.J. Kinahan, chief derivatives strategist for TD Ameritrade. Activity in puts outweighed action in calls by nearly a three-to-one ratio, which Kinahan said was primarily investors buying puts as a protective move by those holding Time Warner shares.
At least one asset manager who bailed on the stock before the announcement said Time Warner just looked too pricey at the Fox offer price of around $85 a share.
"We compared Time Warner to Netflix and Amazon and felt it was way too rich in terms of valuation," said Diane Garnick, CEO of asset management firm Clear Alternatives LLC in New York. Her firm sold the stock last week.
She said millennials represent a growing part of those who view content but don't use cable as much as older generations.
One event investor, who are commonly called arbitrageurs, said he was relieved he had avoided the temptation to get in on the buy-Time Warner-sell-Fox trade after Fox's offer was first made public in mid-July.
"Thankfully we stayed away," said the investor, who declined to be identified. "Lots of event and arb funds had the long Time Warner and short Fox trade on. I don't think many avoided it."
Additional reporting By Liana Baker in New York and Ross Kerber in Boston; Editing by Dan Burns and Martin Howell