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Educational Article

When Options Contracts Change: An Example of a Contract Adjustment by the Options Clearing Corporation

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Last weekend's Options 101 article discussed situations that would prompt an adjustment of options contracts. Such situations include stock splits and reverse splits, mergers, takeovers, reorganizations, special cash or stock distributions and spin-offs.

That article discussed option traders' responsibility for monitoring the equities whose options they might trade, watching for any company announcements that might prompt contract adjustments. Traders should be on the alert for the changes mentioned above and any relevant dates for such changes to be enacted. Finding out how options contracts will be adjusted is an easy matter once such information is discovered. Any proposed adjustments will be made available on the OCC's site.

For example, Notice 25278, issued on December 23, 2008, noted the contract adjustments for Barr Pharmaceuticals, Inc. resulting from the buyout of Barr Pharmaceuticals by Teva Pharmaceutical Industries Ltd. As of 12/24/08, the root options symbol for BRL would become BVR, the notice noted. No change would be made in the strike multiplier. That multiplier would remain 100.

The price for the underlying, BVR, will be calculated using the formula BVR = .62(TEVA) + 39.90 + cash in lieu of .72 TEVA ADS's. As options traders understand, when an option is exercised, the option writer must meet the requirements of the option contract. In the case of a call that is exercised, the assigned option writer usually delivers 100 shares of the underlying's stock. However, as last week's article noted, it's impossible to deliver .72 of a share of stock, so when a BVR option is exercised, cash is lieu of that portion of a share is delivered along with the other deliverables.

What are deliverables? Mike Babel of the American Stock Exchanged explained deliverables in his webinar produced for the education arm of the Options Industry Council, found at this site. A deliverable is synonymous with "unit of trade." As noted in the previous paragraph, most of the time, it's 100 shares of the underlying. If you're trading index options with European-style settlement and those options settle in the money, it's cash. When a company's actions have prompted adjustments, Babel explains (p. 13) that a deliverable can be the following:

Newly distributed shares (same or other)
Distributed cash
Other forms of shares

If we know how the price for BVR is calculated, what does someone who is long a BVR call contract get if that call holder exercises the option? The December 23 notice from the OCC provides that information, and it's based on both the formula for calculating the value of the underlying BVR and the fact that the multiplier remains 100.

Previously the deliverable on BRL would have been 100 shares of BRL. The new deliverable is 1) 62 Teva Pharmaceutical Industries Limited ("Teva") American Depository Shares (0.62 from the formula for BVR value x 100 multiplier = 62), 2) $3,990.00 cash ($39.90 from the formula for BVR value x 100 multiplier) and 3) cash in lieu of those 0.72 TEVA ADS's.

Of course, it's a little more complicated. We all know how to find a settlement price for a U.S. equity, but what about for the TEVA value used to calculate the cash-in-lieu portion of the deliverable? TEVA is traded as an ADS, an American Depositary Share. Investopedia defines an ADS as a "U.S. dollar-denominated equity share of a foreign-based company available for purchase on an American stock exchange."

The bulletin goes on to note how the settlement value of the TEVA portion of the BVR deliverable will be determined. That settlement will occur through the National Securities Clearing Corporation. The OCC bulletin further notes that the "OCC will delay settlement of the cash portion of the BVR deliverable until the cash in lieu of fractional TEVA shares is determined." The OCC will further "maintain an audit trail of all BVR exercise and assignment activity" until that cash in lieu amount is determined. Then all call assignees and put exercisers will be required to deliver that cash-in-lieu amount, the OCC warns.

As should be obvious, the OCC's bulletins contain important information for those who have either written or are long options on a company whose actions require adjustments in options contracts. (Note: The bulletin also discusses how futures contracts will be adjusted, for the information of those trading futures instead of or in addition to options.)

Confused? Viewing Babel's webinar should provide help, but if you need more, there's a free resource available to options traders. The OIC, the Options Industry Council, can answer your questions and it can do so either via a phone call (1-888-OPTIONS) or by chatting live or by emailing them, with the chat and email options available by clicking through on the site linked above. They will not discuss with you the outlook on your options positions, but they claim that they will explain adjustments and just about anything else you want to know about options and options' trading strategies. Of course, your broker can and should be consulted as well.

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