What happens to an options contract during an all stock acquisition?

Question

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!

Answer 1

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.)

Answer 2

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.

Answer 3

I am not sure the strike price should be changed or not, but I know during the AMD/Xilinx merger (all stock merger with 1:1.7234 ratio), they do adjust the strike price of Employee Stock option. This is from the S4 merger document filed with SEC.

Answer 4

All options in a company acquired for stock (or stock plus cash) will be adjusted to reflect the terms of the merger.

When there's a simple conversion ratio such as 1 for 2 (.50) or 4 for 5 (.80), there's a simple adjustment in shares deliverable for the option contract. If the merger results in fractional shares (such as a 3:2) then there will be a cash-in-lieu adjustment included for the fractional shares.

As stated, all options are adjusted, including OTM options. OTM options only become worthless after a merger if it's a cash merger because expiration is accelerated to the date of the merger.

After the merger, adjusted contracts tend to be less liquid since traders will migrate to the standard options of the aquirer. They'll tend to have wider bid ask spreads and in some cases, only closing positions in the adjusted contracts will be allowed (no new BTO or STO contracts).