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"What Happens to Options During Buyouts?"

Question By Juan

"What happens to options when the company is bought out, like the stock ticker JAVA, what happens to my call options in this buyout?"

Asked on 15 August 2009

Answered by Mr. OppiE

Hi Juan,

When a company is bought out, merged or spun-off, cash and/or shares are exchanged between the participating companies and a new capital structure emerges. Shareholders of the bought out company will end up with shares and/or cash from the purchasing company. There is no one standard way of performing such capital restructures and therefore no single standard way of computing the net effects. However, for shareholders, such activities are usually a good thing as almost all buyouts come with a premium above the prevailing share value of the bought out company. Which means that shareholders should end up with more wealth than they did before the buyout. Now, this is less straight forward for holders of options. The same buyout that benefitted shareholders may or may not equally benefit holders of call options.

When a buyout of a company occurs, options of the bought out company will be restructured as well. Standardized options prior to the buyout will be restructured into Adjusted Options. First of all, all extrinsic value of the existing options before the buyout will be taken out of the price of the option during adjustment. This means that if you bought out of the money options, all of these options will become worthless immediately during adjustment. The rest of the options will undergo complex adjustments to their deliverables as well as pricing in order to fairly reflect the net effect of the new capital structure. These new adjusted options typically have strike prices that do not match the prices that they come with. They may sometimes look like grossly over priced or under priced but in fact they are fairly priced and the net effect shows when the options are exercised.

Most options traders do not hold options all the way through an adjustment as most of the stock action takes place prior to the actual buyout. In fact, as soon as the buyout price is confirmed, stocks would immediately price that in. As in the case of JAVA, ORCL's proposed purchase price of $9.50 per share back in April pushed JAVA stocks all the way into that price range from around the $6.50 region. Extrinsic values of out of the money call options with strike above $9.00 went to zero, became worthless, across all near term expiration months due to the fact that the stock price cannot be reasonably expected to surpass the purchase price. However, out of the money call options of LEAPS going into January 2010 or January 2011 did retain some small extrinsic value as some investors speculate on a possible bid raise or a new competing bidder. At this point, even before the buyout actually takes place, options traders would already be able to seal in their profits if they are holding in the money call options or that a loss would already be determined if they are holding out of the money call options. There is no need to wait til the full restructuring to determine this. Winners could sell and take profit, capturing whatever extrinsic value is left. This is again better than waiting til after the restructure where the extrinsic values would totally diminish.

In conclusion, there are almost no reasons for holders of short term call options to hold on to their options through a buyout since the net win/loss would already be attained before the buyout is completed. Exercising adjusted options is extremely complex and usually do not give buyers of call options any additional profit beyond what they could already achieve when the buyout price is announced. If you are a winner already, it would be best to sell and take profit rather than hold through the adjustment. If you are not already a winner, then it is likely that your position is pretty much worthless now and there is nothing that needs to be done.

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