Favorability of a buyout depends largely on the strike price of your option
Reviewed by Robert C. KellyReviewed by Robert C. Kelly
The announcement that a company is buying another is typically good news for shareholders in the company being purchased, because the price offered is generally at a premium to the company’s fair market value. But for some call option holders, the favorability of a buyout situation largely depends on the strike price of the option they own, as well as the price being paid in the offer.
Key Takeaways
- A call option grants the holder the right to purchase shares of stock at a pre-determined price before it expires.
- When a company decides to buy another company, the target company usually sees its stock price jump.
- If a company is acquired at a higher price than the call’s strike price, the holder can profit from the difference between the strike and the takeover price.
- If the strike price of the call is higher than the market price or takeover price ever is, the option will expire worthless.
- Employees with vested stock options of the target company will typically be compensated by the acquirer.
Strike Price
A call option affords holders the right to purchase the underlying security at a set price at any time before the expiration date. But it would be economically illogical to exercise the option to purchase the share if the set price were higher than the current market price. In the case of a buyout offer, where a set amount is offered per share, this effectively limits how high the share price will rise, assuming that no other offers are made and that the existing offer is accepted.
So, if the offer price is below the strike price of the call option, the option can easily lose the majority of its value. On the other hand, options with strike prices below the offer price will see a spike in value.
Important
Call options are considered to be out-of-the-money (OTM) if they have a strike price higher than the current market price. They become in-the-money (ITM) as the price of the underlying rises above that strike price.
Example
Consider the following real-life event: On Dec. 4, 2006, Station Casinos received a buyout offer from its management for $82 per share. The change in the value of the option on that day indicates that some option holders fared well, while others took hits.
Case in point: on that day, options expiring on Jan. 9, 2007, with a strike price of $70, well below the $82 offer price, rose from $11.40 to $17.30, representing a whopping 52% increase. In contrast, those same options with a strike price of $90, well above the $82 offer price, fell from $3.40 to $1.00, representing a staggering 71% loss.
Should I Exercise Call Options Before an Acquisition?
If you own call options, you should wait until the stock price rises pending an acquisition. This allows you to exercise them at the relatively lower strike price and then sell the shares in the market at a premium.
What Happens to Call Options in a Merger?
When a merger is completed the two companies that merged combine into a new entity. At that time, trading in the options of the previous entities will cease and all options on that security that were out-of-the-money will become worthless. Generally, this is determined by the very last closing price on that stock.
What Happens to Vested Employee Stock Options During Acquisition?
Vested employee stock options contain guarantees, so when a company is acquired employees with vested options will have some options. First is the acquiring company may buy out the options for cash. They may also offer to replace those contracts with options of the acquirer of equal or greater value. If stock options that had been granted are very far out of the money (i.e. “underwater”), however, they may be canceled.
The Bottom Line
Some call option holders handsomely profit from buyouts if the offer price exceeds the strike price of their options. But option holders will suffer losses if the strike price is above the offer price.
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