Over the years, I have been asked many times how a 'corporate action' affects options.
Splits, mergers, acquisitions, and spin-offs are all examples of corporate actions.
The simple answer is that the corporate action does not affect the option owner. It's easier to understand using examples, but first a verbal description.
If you own a call option, you have the right to buy 100 shares by paying the strike price. After the corporate action you still have the right to buy the same 'package' that the owner of 100 shares owns as a result of that corporate action – and you still pay the same price.
The same is true for the put owner, who has the right to sell the package at the strike price.
Call sellers are obligated to deliver that package, if assigned an exercise notice. They receive the strike price.
Put sellers are obligated to buy that package by paying the strike price, if assigned an exercise notice.
1) A stock splits 2 for 1
Joe the trader owns 100 shares, worth $40 each, or $4,000. Because of the stock split, Joe now owns 200 shares, worth $20 each. The 'package' (200 shares) is still worth $4,000.
The options also split 2 for 1. That means the call owner now has the right to buy twice as many shares at one half the price. For example, the owner of five Nov 40 calls now owns 10 Nov 20 calls. Unless the stock changes price, these 10 options are worth the same total as the five 'old' options were worth.
The owner of three Nov 45 calls now owns six Nov 22.50 calls.
The owner of six Jan 40 puts now owns 12 Jan 20 puts.
The trader who sold 16 Dec 35 puts is now short 32 Dec 17.50 puts.
No one made or lost any money. The option owner has the right to exercise the options to buy (or sell) an equal number of dollars worth of the same stock.
Assume your company (YYZ) is taken over and that you own 2 YYZ Mar 50 calls.
Assume the terms of the merger dictate that the holders of YYZ shares receive 0.19 share of the new company stock, plus $9.25 cash, for each share of YYZ owned.
Result: a call owner has the right to receive the same package upon exercising a call option and paying the strike price – $5,000 in this example. The call owner receives 19 shares of the new company plus $925 for each option. Your two calls give you the right to buy 38 shares and collect $1,850 by paying $10,000.
IMPORTANT NOTE: You will NOT want to exercise this option (when expiration arrives) unless it is in the money (ITM). How do you determine if it's ITM? If 19 shares + $925 is greater than the strike price of your call (50 in this example), then the call is ITM and whoever owns it when expiration arrives will choose to exercise (remember you can sell the call option. It will still be the YYZ Mar 50 call, but will have a new ticker symbol.)
If 19 shares + 925 is less than the strike price, then the call option is out of the money (OTM) and expires worthless. But, if the Mar 50 call is OTM, then the Mar 50 put is ITM. The put owner will exercise, deliver $925 and 19 shares, and collect $5,000.
If you own such an option, it's easier to sell it before the market closes on expiration Friday. That way you need not be bothered with exercising.
If you are a covered call writer and the option finishes ITM, you will be assigned an exercise notice and be forced to deliver 19 shares + $925 cash for each call. But, you are covered – you already received those 19 shares plus the cash when the merger was completed. Thus, it's easy to fulfill your obligation to deliver.
Other corporate actions are handled in the same manner. The point to remember is that neither the option buyer nor seller is harmed by corporate action (except of course, if the stock price changes due to that action). Each is protected.