Splits, Mergers, Spinoffs & Bankruptcies
What happens when a takeover occurs before the expiration date at a company where I am short calls in the stock?
Corporate actions such as mergers, acquisitions and spin-offs often necessitate a change to the amount or name of the security deliverable under the terms of the contract. When such adjustments occur, the short call position must deliver the adjusted security at the strike price where the call was sold.
For example, the shareholders of company JKL Inc. have approved a takeover bid placed by Global Giant Co. As a result, holders of JKL stock will now be entitled to .50 shares of Global Giant for every share owned of JKL Inc. Therefore, holders of JKL call options will now be entitled to a deliverable amount of 50 shares of Global Giant for every contract of JKL that they own (100 shares per contract x .5 Global Giant). Investors with short positions in JKL call options are then responsible for delivering 50 shares of Global Giant for every call option assigned.
For the sake of this example, we used a simple conversion ratio. However, not all corporate actions have such clearly defined terms. Often assignment requires the short position to deliver fractional shares and a cash equivalent. An adjustment panel consisting of representatives of the listing options exchanges and one OCC representative (who only votes in case of a tie) determine whether to adjust an option because of a particular corporate action by applying general adjustment rules. Again, whatever the terms, the short position has the potential obligation of delivering the adjusted underlying.
What happens with options contracts if an options exchange delists the options on a particular company?
If a stock fails to maintain minimum standards for price, trading volume and float as prescribed by the options exchange, option trading can cease even before its primary market delists the stock. If that occurs, the exchanges will not add any new series. Trading in existing series may continue on a closing-only basis until they expire. If the primary market suspends trading in the underlying stock before the expiration of outstanding options, the options exchanges may allow closing-only transactions for the options if the underlying begins trading in some capacity (Pink Sheets or OTC). You may want to review OCC’s trading halts policies in Information Memo #30049.
How can I tell if an option contract has been adjusted?
There are several ways that an investor can confirm that an options contract has been adjusted and what the terms of the options contract are.
- Information Memos - OCC’s website offers contract adjustment memos with detailed information on how outstanding option contracts will be adjusted due to a corporate action.
- Sign up at the OCC Subscription Center to receive email notifications on contact adjustments
- Quotes - OIC’s website offers a Quotes page where an investor can enter a symbol to obtain all series and strikes available for that option, as well as a description of the option.
- Series Search - OCC’s website offers a Series Search function that displays all strikes. For any adjusted option there will be a numeral following the letters of the option symbol. At that point, one can search for the Infomemo that describes the adjustment.
- Call 1-888-OPTIONS - Investor Services is staffed with industry professionals who are well versed in discussing options contract adjustments and are able to review the specific details of all option contract adjustments.
Here are two hints that an option has been adjusted.
- The option appears to be mispriced. Review the entire option string or chain of options to see if pricing appears for call and puts in all strikes. It is highly unlikely that mispriced options exist for an entire option class.
- Two option root symbols share the same strike price. In some cases, an adjusted non-standard contract appears alongside a standard, 100-share contract. When looking at a string of option prices for a particular underlying, check if all the symbols are identical. These contracts, while having the same strike price, but will have different option root symbols. In many cases, the price differences between these two contracts may vary significantly.
How are options contracts adjusted for reverse stock splits?
Typically, a 1-for-20 reverse split causes the option contract to be adjusted by changing the deliverable to 5 shares of the new stock. You can expect the contract multiplier to remain 100, and of course, a modified option symbol to reflect a change in the deliverable securities.
You may review how various corporate actions including reverse stock splits affect option contracts in our online Adjustments class.
If you write a covered call and the stock splits 2:1, what happens to my 50 call if the stock price is 45?
In your example, when the stock split becomes effective, the stock would go to $22.50 (45/2) and the new strike would be 25 (50/2). You would now be short twice as many of the 25 calls.
What is the deliverable on an option when the underlying security is converted to the right to receive cash?
As explained in Chapter III of the Characteristics and Risks of Standardized Options document:
"When an underlying security is converted into a right to receive a fixed amount of cash, options on that security will generally be adjusted to require the delivery upon exercise of a fixed amount of cash, and trading in the options will ordinarily cease when the merger becomes effective. As a result, after such an adjustment is made, all options on that security that are not in the money will become worthless and all that are in the money will have no time value." For instance, the in-the-money option holder can choose if he'd like to receive that cash value immediately (by exercising) or to wait for the contract to be exercised at expiration (allowing for their firm's exercise-by-exception thresholds). You may also wish to view Memo #30047 (or the yearly update) regarding accelerated expiration for all-cash-deliverable options.
How are options adjusted in the case of a merger where an election is involved?
In the case of an election merger, the option's deliverable is usually adjusted based on the merger consideration which accrues to non-electing shareholders. If call option holders do not wish to receive the non-electing consideration upon exercise after the contract adjustment, they must exercise in advance of the election deadline and submit elections pursuant to the election procedures described in the proxy statement/prospectus.
How is an option contract adjusted for a tender offer or an exchange offer?
According to Interpretation .03 to Article VI, Section 11, of OCC's By-Laws:
"Adjustments will not be made to reflect a tender offer or exchange offer to the holders of the underlying security whether such offer is made by the issuer of the underlying security or by a third person or whether the offer is for cash, securities or other property. This policy will apply without regard to whether the price of the underlying security may be favorably or adversely affected by the offer or whether the offer may be deemed to be "coercive." Outstanding options ordinarily will be adjusted to reflect a merger, consolidation or similar event that becomes effective following the completion of a tender offer or exchange offer."
In all cases, it is the sole responsibility of the person tendering to comply with terms and conditions of an offer.
What are the procedures for adjusting option contracts in the case of a cash dividend?
Yes, you will want to read this memo that was published by OCC for all details.
What happens to the options on an equity if that company files for bankruptcy? Do the options keep trading until expiration date?
If a company files for bankruptcy and the shares still trade or are halted from trading but continue to exist, the options will settle for the underlying shares. If trading in the underlying stock has been halted, trading on the options will be halted as well. Quite often, the shares begin trading on the Pink Sheets or over-the-counter if delisted from the national stock exchange where they are listed. When they do, the options exchanges usually announce that the options are eligible for closing only transactions and prohibit opening positions. Generally, there are no exercise restrictions.
However, if the courts cancel the shares, whereby common shareholders receive nothing, calls will become worthless and an investor who exercises a put would receive 100 times the strike price and deliver nothing.
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