Yahoo (YHOO, $23.91, up $2.56) put in another big day as talks with Microsoft (MSFT, $26.03, up $0.05) heated up once again. Microsoft is now on board with Carl Icahn’s plan to oust Yahoo’s board and said if that were to happen the company would renew its bid for Yahoo. Yahoo’s options were heavily traded as you would expect and I’ve been flooded with emails on what this all means. Well, I’m going to try and simplify it as best I can based from my point of view. First, let’s take a look at some options. Quotes are from Monday’s close with the percentage gain following:

July 22.50 call (YHQGX, $1.96, up $1.26) 180%
July 25 call (YHQGE, $0.69, up $0.40) 138%

August 22.50 call (YHQHX, $2.95, up $1.41) 92%
August 25 call (YHQHE, $1.65, up $0.79) 92%

For beginning option traders, notice the difference of return on the near-term July options compared to the return for the August options. I wanted to point this out so you can see how options react. The July options expire in 10 days while the August options expire in 38 days. Although the strike prices are the same, the difference between the July and August calls is the time premium. That’s another subject (one we teach in our Option Mentoring courses) too long to tackle in a blog but hopefully you get the idea.

Yahoo has been on a roller-coaster ride since Microsoft announced its bid for the company. There is a ton of action in Yahoo right now and has been for quite some time. However, if you are wrong on either side of the trade, Yahoo can cost you a bunch of money in a hurry.

I was asked the question the other day, “what do you think will happen with Yahoo and what is the “best” way to play it”. I pondered the thought and showed someone who has never traded options the difference in buying the stock and buying an option. It was last Thursday and I pointed out these same four options to them.

I said to buy 100 shares of Yahoo would cost you about $2,200. To buy an option contract for the July 25 calls would have cost about $30 per contract. I told them they could control 7,000 shares of Yahoo for the same price. Each option contract controls 100 shares and they could have bought 70 option contracts for $2,100. As of yesterday’s close, those same option contracts are now worth $4,900.

That sounds exciting right? The flip side of that is if Microsoft would have said over the weekend that a deal was off (again). Remember, we’ve been through this how many times now? Exactly. Over the past few months, Yahoo has been up and down more than Robert Downey Jr. can count and there’s no telling if these current talks will materialize or not.

Back to my story. The bottom line is that I told them if they expected Yahoo would get bought for $30 or higher then the July or August 25 calls would be like playing the lottery. If Yahoo doesn’t get bought and the stock doesn’t recover to $30-$31 then they just blew some money on a Pick 3 number that didn’t hit. It’s as simple as that.

Rick Rouse