In a September 16 post, blogger Bill Burton cautions:
Avoid having option positions open on stocks that will split. Option trading has adequate complexities without dealing with non standard [sic] strikes and changes in contract size that may result from splits. Your head will explode trying to deal with these complications.
What is Burton referencing? In this December 19, 2008 article and this week-later, follow-up article, I detailed some of the strange option-related changes that could occur after stock splits and reverse splits, mergers, takeovers, reorganizations, special cash or stock distributions and spin-offs. Burton was talking about those strange changes.
In recent years, there's been an attempt to standardize the way such circumstances are treated, and the data shown in those earlier articles may no longer apply. What still does apply, however, is the confusion that can result if one is holding such options when changes are effected. For example, I'm looking at a hot mess for option traders who held positions in Allos Therapeutics, Inc. (ALTH), if its shareholders approved and consummated the merger with AMAG Pharmaceuticals, Inc. (AMAG). I haven't confirmed whether that was approved or not because it doesn't change the thrust of this article.
If the merger was approved and consummated, "each existing ALTH Common Share will be converted into the right to receive .1282 AMAG common shares. Cash will be paid in lieu of fractional AMAG shares," according to Options Clearing Corporation's Infomemo #29519. How much cash? I dunno. Neither did the OCC, as of September 26, 2010, when the infomemo was released. "OCC will delay settlement of the cash portion of the AMAG1 deliverable until the cash in lieu of fractional AMAG Common Shares is determined," the memo says, with AMAG1 being the new symbol for those who held ALTH options. Put exercisers and Call assignees will then be required to pony up the cash.
What happens to the options themselves? If you're holding ALTH options, you need to know. Your symbol will change to AMAG1, and you'll have a new deliverable. The new deliverable will be 12 AMAG Pharmaceuticals, Inc. (AMAG) Common Shares plus that cash in lieu of .82 fractional AMAG Common Shares. Confused yet? Maybe explaining what a deliverable is will clear up all the confusion. Or maybe not.
In my December 26, 2008 article linked above, I noted that Mike Babel of the American Stock Exchange explained deliverables in his webinar produced for the education arm of the Options Industry Council. "A deliverable is synonymous with 'unit of trade,'" he explained. Most of the time, it's 100 shares of stock in the underlying. For indices with European-style settlement and they settle in cash, it's cash.
In this case, it's obviously not 100 shares of AMAG stock or ALTH, either. So, let's see if I can reword this in a different way for those who haven't yet caught on. Previously, the deliverable for ALTH would have been 100 shares of ALTH stock. For example, if you'd sold a put as a way of buying the stock at a lower price (lower by the amount of the put you'd sold), and that put was in the money at expiration and had been exercised, you would be owed something. What would that something be? As we've established, before any merger, that would have been 100 shares of ALTH stock. Now, however, the new deliverable will be .1282 AMAG common shares x 100 multiplier, which stays the same in this case, which equals 12.82 shares of AMAG. Therefore, for each AMAG1 (formerly ALTH) option contract that's exercised, you'd be due 12 shares of AMAG common shares and cash that would be delivered in lieu of that 0.82 share.
Even more confused? How will the strike prices and option prices change? You may notice that your option appears to be mispriced. You may be the owner of a non-standard option that's trading alongside a standard option that has a deliverable of 100 shares of AMAG. The price of the options at the strike you held will be recalculated to reflect how much it is now in or out of the money.
Obviously we can all figure this out with a little effort and a little attention to the OCC's bulletins. If you're trading stocks that are rumored to be up for buyouts, acquisitions, splits, out-of-the-blue cash dividends or other unusual events, you need to go to the Options Clearing Corporations site and take one of their educational courses on options actions in such situations and then sign up for their bulletins, so you'll be alerted to changes.
But why the heck would you want to do that? I agree with Burton. Options trading can be complicated enough without complicating it further. This is one of the reasons that Option Investor has always counseled newbie and most other options traders to stay away from earnings plays. Experienced traders might tackle them if they have a thorough understanding of how a particular stock moves before and after earnings and how volatility changes in its options before and after earnings. Some traders love the razzle-dazzle of earnings plays. For most of us, it might be a good idea to avoid too much razzle-dazzle.
Burton speaks to a larger issue, too, beyond the complications associated with splits, reverse splits, special cash dividends, mergers and acquisitions. We options traders have enough stacked against us when we trade in these market conditions, often times against high-frequency traders or computers programmed with special algorithms. We have a world of options and options strategies from which to choose. Why complicate our trades?