What Happens to Short Call Options During a Buyout?

Buyouts may have complex terms that require significant adjustments to call options.
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A buyout occurs when one corporation takes over another one. Some buyouts are prearranged between two companies and are called "friendly" buyouts. Hostile buyouts, on the other hand, involve struggles for control of the target company by one or more acquirers. After a buyout, stockholders of the acquired company exchange their old shares for new ones from the acquirer. Buyouts affect not only stocks, but also derivative securities that obtain value from their underlying stocks. Calls are one such security. If you're a call seller, your response to a buyout is dictated by the rules of the stock exchange.

Call Options on Stock

Calls are contracts linked to a particular stock called the "underlying" stock. The buyer of a call option has the right to exercise the option (called taking a "long position") by buying 100 shares of the underlying stock for a fixed price, called the strike price, on or before a specified expiration date. The buyer pays cash — the premium — to a seller, who writes the short call option. The seller is obligated to deliver the shares of stock if the buyer exercises the call — something that would only occur if the stock price was higher than the strike price. "Covered" call writing involves already owning the underlying stock when you write the call. It is considered a safe, conservative investment that might attract young nesters looking to increase their income.

Buyouts for Cash Only

An all-cash buyout halts call option activity on the effective date of the takeover. At that time, the call seller must pay the call buyer the excess of the per-share buyout price above the call strike price. For instance, if the strike price of an XYZ Corp. call is $80 and the buyout price from ZYX Corp. is $87 a share, the call seller will have to deliver $7 times 100 shares, or $700, to the call buyer. Had the offer been for $79 a share, which is below the strike price, the call would be worthless, and no money would change hands.

Buyouts for Stock Only

A stock-only buyout would be straightforward if the terms specified the exchange of one old share for one new share. Often, the terms involve fractional shares, and the stock exchange adjusts the terms of call options to reflect these kinds of stock-only buyouts. This is necessary because normal call options always pertain to 100 shares of stock. A fractional share buyout changes the number of shares controlled by a call and must be adjusted accordingly. In addition, the stock prices of the acquirer and target companies are unrelated, so the call strike price must be changed to a strike price appropriate for the acquirer's stock price.

For example, if acquirer ZYX offers ¼ share for each share of target XYZ Corp, the call option would be modified to reflect 25 shares of ZYX Corp. and a strike price determined by the stock exchange. If the call buyer exercises the option, the call seller has to provide 25 shares of ZYX and will receive 25 times the new strike price in return.

Mixed Buyouts

Many buyouts involve cash and stock. If the share offer from ZYX Corp. also included $10 per share in cash, then the call seller might not only have to deliver the 25 shares at the strike price, but also pony up 25 times $10, or $250. Buyouts can get pretty hairy. For instance, if the two firms were in the fur business, part of the buyout might include a mink stole for each 200 shares of XYZ Corp. Complicated deals get referred to managers at the stock exchange, who will issue instructions on how call sellers are to proceed.

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