Slack Technologies Inc. headquarters. Photographer: David Paul Morris/Bloomberg

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Salesforce .com announced on December 1 last year that it had entered a merger agreement to buy Slack. The terms of the deal are for Slack shareholders to receive $26.79 in cash and 0.0776 Salesforce shares for each Slack share. This valued the deal at $27.7 billion based on Salesforce’s November 30 common stock price of $241.35.

News of the deal started to leak on November 25. Slack’s stock on November 24 closed at $29.58 and jumped to $40.70 the next day. Based on Salesforce’s stock price of $241.35 Slack’s stock would be priced at $45.52.

As of Wednesday, February 24, closing Slack shares were worth $42.35 and Salesforce were $240.47. While Slack’s shares should be valued at $45.45, they are trading at a 7.3% discount. This is not unusual as there is a risk the deal may fall apart, Salesforce stock may drop and the time value of money is involved since Salesforce said the deal should close during its second fiscal quarter which runs from May to July.

Note that Salesforce’s stock would have to drop to $200.52 to have Slack’s valued at its current price of $42.35. This is a 16.6% discount to Salesforce’s current $240.47 price.

There is a way to take advantage of the discount and provide some downside protection by selling Put options on Slack shares. While there are a number of risks, which I’ll outline below, it should be possible to generate a return of 2.5% to 4.5% over the next few months or an annualized rate of return from 8% to 14.4%, respectively, and possibly higher.

Disclosure: I have sold Puts on Slack that expire on June 18.

Selling Put options

When an investor buys a Put option it gives them the right to sell a stock at a given price. This is typically done when the investor expects the price of the stock to decrease. When this happens the value of the option goes higher as the selling price of the stock (the strike price) is set but the purchase price is lower. However, since options have an expiration date if the price does not decrease enough soon enough the option could expire worthless or be valued less than what the investor paid for it.

When an investor sells a Put it obligates them to purchase the stock at the strike price, if the buyer exercises the option. The seller receives cash for selling the option.

An investor who sells a Put is expecting the price of the stock to rise above the strike price and then the Put option is worthless. The seller of the Put can still make money if the cash they receive is more than what the option is worth when the expiration date comes along. The biggest downside for the Put seller is if the stock price craters and they have bought the stock at the strike price but it is worth substantially less.

Something else to keep in mind is that the investor’s brokerage firm will probably want the investor to have enough cash to cover the trade if the Put option is exercised.

Selling Slack Puts to generate income and return

There are different levels of risk and reward when selling options. They are dependent on how close or far the strike price is from the current stock price and how soon or far the expiration date is from the day the option is bought or sold. The volatility of a stock also comes into play.

In Slack’s case due to the high likelihood the Salesforce acquisition will occur the premium, due to lower volatility of Slack’s stock, will be lower than normal.

Salesforce has also said that it expects the merger to close in its second fiscal quarter which runs from May to July, or three to five months from now. To generate enough income through selling a Put and to take advantage of a “known” timeframe going out to June, which has a decent number of options already traded, looks to be a good month to choose.

To get a handle on how much income and return can be generated look at the June 18 Put with a $40 strike price. Besides generating income by using a strike price below where Salesforce and Slack are trading, it creates a cushion if Salesforce declines.

June 18 Put with $40 strike price

  • 114 days or just under four months to expiration
  • $1.00 Bid price or the lowest amount someone is willing to pay
  • generates a 2.5% return
  • or 8.0% annualized return

However, the Ask price, or the lowest amount someone is willing to sell is $1.80

  • This generates a 4.5% return
  • Or 14.4% annualized return

One way to get the best price when selling a Put is to start just below the current Ask price and see it someone is willing to buy at that price. In this example start to $1.75 and wait a few minutes. If no one buys it move it down $0.05 every few minutes until the transaction occurs or you reach the minimum you are willing to accept.

With a $40 strike price Salesforce stock could drop to $170.23, or 29.2% below where it closed and Slack’s stock would still be worth $40. When you include $1.00 in option premium the breakeven price for Salesforce stock drops to $157.35 or 34.6% below where it closed.

If you want to generate more income and return and feel comfortable with higher breakeven levels for Salesforce stock you can use higher strike prices such as $41 or $42 or even higher. It depends on your risk tolerance.

Salesforce.com stock price

StockCharts.com

Risks to the trade

While it looks like the merger will occur, it isn’t guaranteed so there are a number of risks to this trade.

The first is that Salesforce.com plans to announce its fiscal fourth quarter results (ended on January 31) after the close today, Thursday, February 25. If the results or outlook are below what investors are expecting, Salesforce’s stock could drop enough to wipe out the discount and option premium.

Another risk is that the merger falls apart and Slack’s stock falls back to where it was before the merger or around $29. This would mean the investor has to buy Slack at $40 but it is only worth $29. The $1 or slightly more in the income generated helps but not nearly enough.

Even if Salesforce announces strong results and a positive outlook, its stock could still fall more than the current 7.3% discount and an additional amount to where Slack’s stock is worth less than $40 ($41 strike price minus the $1 premium the investor received for the Put option).

With the merger consisting of both cash and stock Salesforce’s shares would have to fall more than 16% to turn the trade into a loss. While a large drop, it could happen.

Slack stock price

StockCharts.com

Please click here to read the original article as posted on Forbes.

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