A:

Typically, the announcement of a buyout offer by another company is a good thing for shareholders in the company that is being purchased. This is because the offer is generally at a premium to the market value of the company prior to the announcement. However, for some call option holders, whether a buyout situation is favorable will depend on the strike price of the option they hold and the price being paid in the offer.

A call option gives the holder the right to purchase the underlying security at a set price at anytime before the expiration date, assuming it is an American option (most stock options are). Effectively, no one would exercise this option to purchase the shares at the set price if that set price was higher than the current market price. In the case of a buyout offer, where a set amount is offered per share, this effectively limits how high the shares will go, assuming that no other offers come in and the offer is likely to be accepted. So, if the offer price is below the strike price of the call option, the option can easily lose most of its value. On the other hand, options with a strike price below this offer price will see a jump in value.

For example, on December 4, 2006, Station Casinos received a buyout offer from its management for $82 per share. Looking at the change in the value of the options that day gives a clear indication that some call option holders made out well while others were hit hard. On that day, the Jan 09 options with a strike price of $70, which was well below the offer price of $82, rose from $11.40 to $17.30 - a 52% increase. On the other hand, Jan 09 options with a strike price of $90, which is above the $82 offer price, fell from $3.40 to $1 - a 71% loss.

Some call option holders enjoy a healthy profit as a result of a buyout if the offer price comes in above the strike price of their options. However, option holders will be hit hard if the strike price is above the offer price.

For related reading, see the Options Basics tutorial.

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