Options FAQ: Splits, Mergers, Spinoffs & Bankruptcies

by The Options Industry Council | April 13, 2011 5:40 pm

Splits, Mergers, Spinoffs & Bankruptcies Questions


Splits, Mergers, Spinoffs & Bankruptcies Answers

Q: What happens if I am short calls in the stock of a company which is subsequently taken over before the expiration date?

A: Corporate actions such as mergers, acquisitions and spin-offs will often necessitate a change to the amount or name of security that is deliverable under the terms of the contract. When such adjustments occur, the short call position is responsible for delivering the adjusted security.

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 a 1/2 share of Global Giant for every share of JKL Inc. they own. 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 are long (100 shares per contract x .5 Global Giant). Investors with short positions in JKL call options would then be responsible for delivering 50 shares of Global Giant for every call option assigned.

For the sake of this example, a simple conversion ratio was used, though not all corporate actions result in such clearly defined terms. Often assignment will require the short position to deliver fractional shares plus cash equivalent. An adjustment panel consisting of representatives of the listing options exchanges and OCC (who only votes in case of a tie) makes a determination whether to adjust an option as a result 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.

For access to specific Contract Adjustment Memos, you may search by option root symbol here:

http://www.optionsclearing.com/market-data/infomemos/infomemos1.jsp.

 


Q: What happens with my options contracts when a company is delisted from an options exchange?

A: If a stock fails to maintain the minimum standards for price, trading volume and float prescribed by the options exchange, option trading can be wound down even before the stock is delisted by its primary market. In that case, no new series would be added at expiration. Trading in existing series would continue until they go “off the board”. If trading in the underlying stock is suspended by its primary market for an extraordinary reason before the expiration of outstanding options, the options exchange will specify a procedure for the orderly liquidation of option open interest in a special bulletin.

 


Q: I was wondering if there is an industry standard to how options holdings are adjusted to reflect a stock split or stock dividend on the underlying security.

A: You can see a basic discussion on how options are adjusted in Chapter III – Options on Equity Securities from The Characteristics and Risks of Standardized Options.

Remember that each adjustment can be handled differently to reflect the unique terms of the stock adjustment. The Options Industry Council website offers an online interactive class regarding option contract adjustments that can occur as a result of a wide variety of corporate actions.

You can also find memos that pertain to all adjustments on the www.optionsclearing.com website.

We also offer customers an email alert pertaining to these memos.

If you have questions pertaining to a specific adjustment you can call an Options Specialist at 1-888-OPTIONS (1-888-678-4667).

 


Q: How can I tell if an option contract has been adjusted?

A: 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.

Here are two hints that an option has been adjusted.

 


Q: XYZ Inc.’s stock was recently trading at .60 cents before undergoing a 1 for 10 reverse stock split and is now trading at $6.00. Is my call option with a strike of $5 that was outstanding at the time of the reverse split now in-the-money by $1.00?

A: No. The call option should not be in-the-money. All XYZ Inc.’s option contracts that were outstanding on the effective date of the 1 for 10 reverse split have would be adjusted to reflect the reverse split. An option contract for a reverse split is typically adjusted as follows:

The value of 10 NEW shares of XYZ Inc stock @$6.00 per share is $60.00 dollars. The value of the strike price (if exercised) is $500.00. To determine the point at which the post-split stock needs to be for the $5.00 call to be in the money, divide the value of the strike ($500.00) by the number of shares that Underlies the contract (10). This would indicate that the stock would need to be trading above $50 per share for this adjusted contract to be in the money.

For additional educational information concerning adjustments to options due to splits and mergers please refer to our online interactive classes. You can also view previous adjustment memos posted to the www.optionsclearing.com website.

 


Q: How are options contracts adjusted for reverse stock splits?

A: Typically, a 1 for 20 reverse split would cause 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 the option symbol would most likely change to reflect a change in the deliverable securities. You may want to take a look at the recent PALM split, which was a 1 for 20 split, to study an actual situation.

Also, visitors have the opportunity to review how various corporate actions including reverse stock splits impact option contracts via our online interactive classes.

 


Q: I own a September call option for company XYZ. News has come out stating that XYZ is the subject of a cash buyout that is expected to close in May. Assuming that the merger is approved, what can I expect to happen to the call option I own. (Submitted 4/03)

A: 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.

Sign up for our Online Options Classes to learn more about how options are adjusted due to corporate actions.

 


Q: Would options on MGM be adjusted? If someone is long call, does he/she have to exercise in order to get the dividend? What are the guidelines for the MGM dividend? How does cash distribution (other than the ordinary dividend) require an adjustment?

A: While it is true that in order for a call holder to be entitled to a NORMAL or regular dividend, they would need to exercise that contract before the ex-date, adjustments are often made for “extraordinary” cash distributions. This is mentioned in Chapter III of The Characteristics and Risks of Standardized Options: “As a general rule, no adjustment is made for ordinary cash dividends or distributions. A cash dividend or distribution by most issuers will generally be considered ‘ordinary’ unless it exceeds 10% of the aggregate market value of the underlying security outstanding.”

As discussed in an OCC Information Memo #19656 (PDF), the declared dividend amount represented almost 40% of the price of the underlying security. Adjusting the options contract is fair and equitable, and pursuant to Article VI, Section 11 of OCC’s By-Laws, a panel of OCC’s Securities Committee has determined to adjust all MGM by reducing the strike prices by $8.00.

The options markets are considering an amendment to the general rules which, if adopted and approved by the regulators, decrease the precentage deemed to be “extraordinary.” As has been the practice, determination of whether to adjust for cash dividends or distributions in excess of these amounts is made on a case-by-case basis.

 


Q: If you write a covered call and the stock splits 2:1 – what happens to my 50 call if the stock price is 45?

A: 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 own twice as many of the 25 calls.

 


Q: How have options been adjusted for the Ameritrade special dividend?

A: Please refer to the informational memos below:

 


Q: Now that AWE (AT&T Wireless) has been bought out, what happens to my 12.50 call?

A: On May 19, 2004, Shareholders of AT&T Wireless Services, Inc. (“AWE”) approved a proposed merger with Cingular Wireless Corporation. The merger was consummated on October 26, 2004. As a result, each existing AWE Common Share will be converted into the right to receive $15.00 net cash per share. Although the options will not continue to trade, they will continue to exist until they expire or are exercised. For each call that you exercise you will receive the difference between the strike and the cash amount, or $250 for a 12.50 call ($1500 deliverable – $1250 exercise amount). You can read the entire memo detailing this corporate action’s effect on the options here:

 


Q: Sears, Roebuck and Co. and Kmart Holding Corporation recently signed a definitive merger agreement to form a new, combined Company. The merger is expected to become effective by the end of March 2005. The terms of the merger state that individual shareholders may elect to receive cash, an amount of stock in the new combined company, register no preference to receive cash or stock (non-electing) or if no election at all is made, shares are considered to be non-electing shares. How are options typically adjusted in the case of a merger where an election is involved?

A: The option’s deliverable in the case of an election merger 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. You can reference Information Memo #20155 (PDF) for additional information on this topic.

To view information on past option adjustments due to election mergers, visit the Options Clearing Corporation’s website, www.optionsclearing.com. Click on the “Information Memos” link located in the “Important Notices” section on OCC’s homepage. In the “Search For” box enter keyword “election merger.”

 


Q: How are the exchanges going to adjust options on the ETF Nasdaq-100 QQQQ options to reflect the MSFT special dividend?

A: The OCC is anticipating adjusting the options on QQQQ by reducing strikes by 3/8ths. Please note: THE EXACT AMOUNT OF THE NASDAQ-100 INDEX DISTRIBUTION IS NOT ANTICIPATED TO BE AVAILABLE UNTIL AFTER THE CLOSE OF BUSINESS ON DECEMBER 16TH, 2004. Read the most current OCC Information Memo here:

 


Q: Winn-Dixie Stores, Inc. recently declared Chapter 11 bankruptcy protection. What does that mean for my options?

A: Shortly after its Bankruptcy announcement, trading in Winn-Dixie Stores, Inc. stock was suspended from the NYSE and began trading on the OTC Bulletin Board. When a stock does not trade on a national market, the options exchanges will typically allow for investors to enter ‘closing only’ transactions, which is the case for Winn-Dixie Stores. Investors may have to request an option quote from their broker. Investors also have the right to exercise their options versus closing the position in the open market.

 


Q: Has the non-electing consideration for Sears options been determined?

A: Yes, the official results were announced. You can read the memo here:

 


Q: What is the deliverable on an option when the underlying security is converted to the right to receive cash? (Like may be the case with Premcor’s options that converted to the non-electing consideration.)

A: As explained in Chapter III of the disclosure 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.”

Premcor’s OCC Info Memo Link: http://www.optionsclearing.com/components/docs/market-data/infomemos/2005/sep/20965.pdf (PDF)

 


Q: What is the deliverable on an option when the underlying security is converted to the right to receive cash? (Which may be the case with Royal Dutch options if the RD shares are converted to a cash consideration.)

A: As explained in Chapter III of the disclosure 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 his firm’s exercise-by-exception thresholds).

For the most recent memo (as of July 17, 2005) on RD, click here: OCC Information Memo #20797 (PDF)

 


Q: A company I own options in recently declared Chapter 11 bankruptcy protection. What does that mean for my options?

A: Following a bankruptcy announcement, trading in the underlying stock might be suspended by the primary exchange that lists the security. If trading in the underlying stock has been halted, trading on the options will be halted as well. However, if the underlying stock begins trading on the OTC Bulletin Board or on the “Pink Sheets,” investors will be able to close out any existing positions, i.e., ‘closing only’ transactions. No new or ‘opening’ trades are permitted. Investors may also exit their position through exercise instructions to their broker resulting in the physical delivery of the bankrupt company’s shares.

 


Q: How are options typically adjusted in the case of a merger where an election is involved?

A: An option’s deliverable in the case of an election merger 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 after the contract adjustment, they must exercise in advance of the election deadline. And as shareholders, they must elect pursuant to the election procedures described in the proxy statement/prospectus.

To view information on past option adjustments due to election mergers, visit the Options Clearing Corporation’s website, www.optionsclearing.com. Click on the “Information Memos” link located in the “Important Notices” section on OCC’s homepage. In the “Search For” box enter keyword “election merger.”

 


Q: How is an option contract adjusted for a tender offer or an exchange offer?

A: 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.”

Call option holders must exercise their option no later than the expiration date of the tender offer or exchange offer in order to tender shares. In all cases it is the sole responsibility of the person tendering to comply with all the terms and conditions of an offer.

 


Q: Is there any anticipated option adjustment for the USG Rights offering?

A: Yes, the current information on that offering’s adjustment to the options is available here:

http://www.optionsclearing.com/components/docs/market-data/infomemos/2006/feb/21406.pdf.

 


Q: Where would I be able to read about the new adjustment methodology to eliminate rounding that is being implemented on September 4, 2007?

A: You can read about the new methodology here:

http://www.optionsclearing.com/components/docs/market-data/infomemos/2007/aug/23348.pdf.

 


Q: Are there new procedures for adjusting option contracts in the case of a cash dividend?

A: Yes, the new procedures begin on February 1, 2009. You will want to read this memo that was published by The OCC for all details: http://www.optionsclearing.com/components/docs/market-data/infomemos/2008/nov/25133.pdf.

 


Q: What happens to the options on an equity if that company files for bankruptcy?  Do the options keep trading until expiration date?

A: 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.  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 and when they do the options exchanges will usually announce that the options are eligible for “closing only” transactions – no opening positions are allowed.  Generally, there are no exercise restrictions.

However, if the courts cancel the shares, whereby common shareholders receive nothing (as was done a few years back with Delta Air Lines), 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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