Let's say for the sake of the question you're given the following scenario:

  • Company BIG is trading at $10/share
  • Company SML is trading at $40/share
  • BIG reaches an agreement with SML for an all stock acquisition/merger whereas SML shareholders will receive 5 shares of BIG for each share they own

How would a call option in SML be affected by this deal?

Specifically, I'm unsure of the following:

  1. How is the strike price for SML options affected by the merger? I've read that the only thing that would change is the deliverable (i.e. instead of receiving 100 shares in SML when exercising, you'd now receive 500), but this result in SML contracts having inflated strike prices due to the difference in the value per share pre-merger...
  2. What happens to out of the money SML options? I've read that they'd instantly become worthless... wouldn't this only apply to an all-cash deal? If the deal involved a transfer of shares, wouldn't the contract be adjusted based on the terms of the deal with the deliverable changing from shares of SML to shares of BIG?
  3. Assuming the deliverable for the SML options are converted to shares of BIG, how are these converted contracts traded... in other words, are they liquid or only useful if you decide to exercise them?

I just started trading options a few weeks ago and haven't been able to find answers to these questions anywhere... any help from an experienced trader would be much appreciated!

According to this article:

With an all-stock merger, the number of shares covered by a call option is changed to adjust for the value of the buyout. The options on the bought-out company will change to options on the buyer stock at the same strike price, but for a different number of shares. Normally, one option is for 100 shares of the underlying stock. For example, company A buys company B, exchanging 1/2 share of A for each share of B. Options purchased on company B stock would change to options on company A, with 50 shares of stock delivered if the option is exercised.

This outcome strongly suggests that, in general, holders of options should cash out once the takeover is announced, before the transactions takes place. Since the acquiring company will typically offer a significant premium, this will offer an opportunity for instant profits for call option holders while at the same time being a big negative for put option holders. However, it is possible in some cases where the nominal price of the two companies favours the SML company (ie. the share prices of SML is lower than that of BIG), the holder of a call option may wish to hold onto their options. (And, possibly, conversely for put option holders.)

  • I read that article, but it makes no sense that the strike price wouldn't change... take an extreme example where an acquiring company is trading at $10,000/share the the acquiree is trading at $10/share. By that logic, it'd make all options for the acquiree instantly in the money. Or if you take the inverse of that where the share values are swapped, it'd make practically all options for the acquiree out of the money. That wouldn’t make any sense… – William LeGate Sep 1 '16 at 3:49
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    Wouldn't the only logical way to handle this be to adjust the strike prices based on the stock conversion ratio agreed upon in the merger? – William LeGate Sep 1 '16 at 3:55
  • @WilliamLeGate I would suggest that the need for a "one-size-fits-all" rule results in the rules that are applied. Holders of options will have a considerable amount of time to sell their options before the acquisition is finalised. Holders of call options will have profited handsomely while holders of put options will have suffered. This is just as one would expect. The problem of adjusting the strike price is that it would work against the call option holders. This is because the share price of BIG will typically (rightly) fall on announcing the acquisition. – Nick R Sep 1 '16 at 4:28
  1. Depends on your contract, cash or shares delivered? If shares, then you get 5 BIG shares. Theres no longer any options. If you sell instantly, theoretically you will net the $10 difference + profit above strike. If cash, same thing just that you get cash $50 less strike.

  2. Applies to cash and stock deals Options are binary, never pro-rated.

  3. if converted, basically you end up with BIG shares.

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