Ask the Institute

Ask the Institute Archive

DATE: September 07, 2001

QUESTION:
What if I buy stock and then write a covered call LEAP option, for example out to 2006, and the company is the target of a takeover bid for cash?


ANSWER:
Let's look at a hypothetical position:

Own: 100 XYZ current price $67
Sold: 1 XYZ Jan 60 (2003) call

The very next day, ABC Corporation announces that it is buying XYZ Corporation for $70 per share in cash effective immediately. What happens to the above positions?

First, what happens to the 100 shares of XYZ Corp. that you own? Upon the effective date of the cash merger, for every one share of XYZ Corp. you own, you will receive $70 per share. This amount is equal to $7,000 (100 XYZ Corp. times $70 per share).

Next, what happens to the 1 XYZ Jan 60 (2006) call? On the business day immediately following the effective date of the merger, each XYZ Corp. contract will be adjusted to require, upon exercise, the per-contract delivery or receipt of: 100 times the Cash Merger Consideration ($70 per share), which will be $7,000 in cash plus any additional interest component that may be paid. Strike prices will remain the same, and the option symbols will remain the same.

What do these two things mean to your overall account? First, you sell 100 XYZ at $70 per share for $7,000. Next, if/when you are exercised you will need to deliver the difference between the contract value of $7,000 and the exercise value of $6,000. In summary, you will need to deliver $1,000 ($7,000 - $6,000) to the holder of the option to fulfill your obligation. Existing XYZ open interest will remain open until it is exercised or expires.

Each merger, stock split, takeover, etc., is unique and may be different from the last one.


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