From Our E-mail Archives: We received a question about the effect of mergers on LEAPS options. Our Head Trader, Robb Reinhold, answered the question, plus described the concept of merger arbitrage.*
-----Original Message-----
From: Colin M.
Hi Robb,
Say you own 2016 LEAPS (Long-term Equity AnticiPation Securities) in Heinz (Ticker: KHC) at $60 and Warren Buffet decides to come in and acquire Heinz privately at $62.50 tomorrow.
Would your LEAPS immediately lose all of their extrinsic value and drop to $2.50 in value? Do LEAPS still retain some of their extrinsic value when the underlying stock is taken private?
Thank you,
Colin
-----Reply Message-----
Hi Colin,
Technically speaking, if that scenario happened, then the Implied Vol (Volatility) and Time Value would go to almost zero immediately. However, in real life, that never happens. Even after the announcement of a merger, the prices don't change automatically since the actual merger or buyout is typically months away and each company has to go through a process of possible regulatory approval, shareholder approval, integration questions, etc.
So, there will still be at least a month or two before the actual merger happens. During this time, there is an entire trading strategy called merger arbitrage, where traders will take positions based on the likelihood of the deal closing or not.
For example, let's say the Heinz buyout is announced at $62.50. The first thing to determine is if the offer is all cash, half cash/half stock or an all stock deal. If there is stock involved, then there is now the underlying risk of the acquiring company's stock going down, so this will be built into the market price and Heinz might only trade at $61.50 on the day of the announcement.
If traders think that there may be big regulatory or shareholder hurdles, then the price of Heinz might only be $58 due to the risk of the deal not closing. On the other end of the spectrum, I have even seen stocks trade above their buyout price if traders think that a competing, higher bid might come in for the stock.
Due to all this uncertainty, there will still be extrinsic value built into the options. The less likely that the deal will get done will equal a greater extrinsic value. However, as the stock gets closer to the actual buyout date and hurdles are removed, the risk premium comes out of the stock where it will move up to 61.40 or higher and the risk premium will leave the options as well.
Hope this helps and have a great weekend,
Robb
* NOTE: Some original wording has been slightly modified for legibility. Also, stop using ketchup on your hot dogs. You're too old for that. Use a spicy mustard instead.
