Reader Dwight sent along this tidbit from OptionMONSTER ($) and I must confess it piqued my interest.
As you will see, the trade described in this story makes sense only if you believe the acquisition of Merrill by Bank of America will not close, or will appear to be in serious doubt. That seems like a very remote idea. However, the trader in question may be taking a other low cost, high payoff on extreme events type bets, This would seem consistent with a Black Swan trading approach. And we do happen to live in extreme times.
The open interest and value of the trades is teeny. This story is a curiousity rather than a news item. But remember, credit default swaps on Treasuries were once seen as a curiousity too, and now they trade actively enough to be seen as a meaningful barometer.
Now of course, the deal would not have to fail, merely look in serious enough doubt to tank Merrill’s stock even further before option expiration. Would a price renegotiation do that? Unlikely, since the Merrill shareholders have nowhere to go. But note there were calls for improved terms to Bank of America almost as soon as the deal was announced. From Reuters on October 1, “Merrill sale still seems shaky“:
Some investors still can’t believe that Bank of America’s deal to buy Merrill Lynch & Co Inc is going through.The spread between Merrill’s share price and the implied price of its shares under the deal’s terms has been wide, which has some investors thinking Bank of America could want to renegotiate the price….
When the commercial bank agreed to buy the investment bank, it said it would exchange 0.8595 shares for each share of Merrill. Based on Bank of America’s share price on Tuesday, that values Merrill Lynch shares at just over $28, while the shares closed at $25.30 on Tuesday.
That was an overpayment of 10.6%. Using that exchange ratio, and BofA’s closing price Friday of $11.47, the price to Merrill shareholders is $9.86. The stock closed at $8.34, so the overpayment has increased to 18.2%. So it is not completely crazy to think the deal might be retraded. Will that lead to the stock going into a swoon deep enough that it loses more than 3/4 of its newly low price? It shouldn’t, if the process is managed at all well, but nothing is a given these days.
From OptionMASTER (note the story was posted before the end of the trading day; Merrill closed with a very small gain):
Merrill Lynch is in steady decline, down another 3 percent today as traders are buying bankruptcy puts.MER, which was at $20 on Nov. 4, has traded lower all but two days since and is down more than 55 percent to its current level of $8.47. Shares were above $50 in May and began the year near $60.
One trader was taking the bankruptcy play, buying 15,000 of the January 2.5 puts for $0.50 in one block against open interest of 8,116 contracts. This trade will pay off only if MER is below $2 at expiration.
Today puts are out-trading calls more than 2 to 1 on the day.
The implied volatility for MER has climbed to all-time highs, hitting 224 percent. It was down at 75 percent just a month ago. Historical volatility is down to 154 percent, having come in from highs at 233 percent.
DD 
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“One trader was taking the bankruptcy play, buying 15,000 of the January 2.5 puts for $0.50 in one block against open interest of 8,116 contracts. This trade will pay off only if MER is below $2 at expiration.”
This trade makes no sense unless you think there is more than a 20% chance of complete (unrecovered, unbailed out) bankruptcy within the expiration time. You pay in 50c, and you get out 2.50 if you are right.
The 5’s cost 1.20, which is almost the same ratio (24%), but these will pay out in the more likely case of a partial decline in value.