A very common question that comes up every time a merger, split or acquisition takes place is how corporate action affects stock options. Generally, the effects of a merger on stock options are positive, but it also depends on the structure and timing of the merger. Besides, it is a matter of whether an investor holds call options or put options. Mergers are typically positive for call options because they are locked at prices above the stock price valid prior to merger and this is rewarding for call option holders.
A call option gives an individual the right to buy 100 shares of the underlying stock by a certain date (expiration or maturity date) at a certain price (exercise or strike price). Investors who hold call options hope that the share price will rise above the strike price before maturity so that they exercise their option and realize a profit. In case of a merger, call options on the stock of the acquired company must be adjusted according to the terms of the deal so that the contract is kept in line with the original terms that were valid before the merger took place.
To better understand how a merger affects stock options we assume that an investor holds call options on company X that is acquired by company Z. The call options on the stocks of company X are adjusted according to the terms of the deal with company Z, known as share exchange. If the investor holds an option to buy a share of company of X for $1 and the deal of the merger announces that every X share is exchanged for 2 Z shares, after the merger the investor will have the right to buy 2 shares of company Z for $1. Therefore, the deal is carried over to the call options.
Another possibility is that company Z makes a cash offer to acquire the shares of company X, known as a cash buyout. In this case, the call options of company X stop trading as soon as the merger takes place and investors who hold these options receive the corresponding cash amount that the buyout payment is in the money. For instance, if the buyout price is $30 per share and the strike price on the option contract is $20, as soon as the merger takes place and the shares of company X stop trading, the contract will be settled and the holder of the call option will receive the $10 difference, known as in-the-money value or $1,000 per contract (100 shares x $10 per share). This amount has to be paid by company Z that acquires company X.