A trader who is short call options has sold call option contracts to earn the premiums as income. If the option buyer elects to exercise a contract, the trader who is short the option must fulfill the contract by delivering the underlying stock. If the company represented by the underlying stock is bought out, the obligations of the option seller will change.
Call Option Function
One call option contract gives the option buyer the right to buy 100 shares of the underlying stock at a preset price called the strike price. The option seller — who is short the contract — will deliver the shares if the buyer elects to exercise the contract, and the seller will receive the strike price for the shares. If a call option is exercised and the option seller does not own the shares, he must buy them on the stock market so they can be delivered. The short option trade loses money if the underlying stock price moves above the contract strike price.
If the buyout offer on the underlying stock for a call option is an all-cash offer, the options stop trading on the day the offer becomes effective. The trader who is short the option contracts must deliver cash to the option buyer if the stock buyout price is above the strike price of the option. For example, the stock is bought out for $50 per share. If the call option has a strike price of $40, the option is $10 in the money and the short option trader would have to pay $1,000 — $10 times 100 shares — to the option buyer. If the call option strike price was $50 or higher, the short option would become worthless to the buyer and no money would be due to the option buyer.
If another company buys out the stock underlying the call option with an all-stock buyout offer, the terms of the call option are adjusted to reflect the buyout share exchange. For example, a company buys out the stock of the call option shares with an offer of one-half share of the new company for each of the underlying stock shares. After the buyout, a trader who is short call options on the bought-out shares would deliver 50 shares of the purchasing company if the option was exercised.
Stock Plus Cash
Many buyouts are stock-plus-cash offers. For a call option, the share ratio changes like the example above and the cash attaches to the option if exercised. If in the example above, the buyout for one-half share of the new company also included cash of $5 per share, the short call option trader would have to deliver 50 shares of the purchasing company plus $500 if the call option is exercised. If a stock buyout becomes more complicated, a committee at the options exchange will decide what happens with short call option positions and the trader's broker will let the trader know what he must do with the sold call options.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.