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, Random Roger (173 clicks)
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Roger Nusbaum submits: The Striking Price in this week's Barron's is about the potential complexity of adjusted options. The article gives some examples of strange option adjustments but misses a key point. Often when options get adjusted for something like a merger, spinoff or special dividend the appearance is created that the options are giving away money for nothing -- a lot of money.

Capital markets never give away a lot of money. If you see an option that is priced too good to be true, it is. What makes this tough is that people often think there is free money, and the phone rep at the discount firm won't be able to explain to you why you are wrong.

Fair warning right here. Free money will never be more than a few cents. If you see an option with many dollars of free money, you don't have the whole story.

Here is a made up example. Ginormous Inc. trades for $40 per share. It spins off Teeny Tiny at $7 per share. A shareholder of 100 old Ginormous at $40 now owns 100 Ginormous at $33 and 100 Teeny Tiny at $7. It is the same $4000 worth of stock before and after, but allocated between the two stocks after the spinoff.

Before the spinoff a call option struck at $40 expiring in two months might trade for $1.50. That same option after the spinoff will still be at $1.50 even though Ginormous is now at $33. Before the spinoff it delivered $4000 worth of stock in the form of 100 Ginormous shares. After the spinoff it still delivers $4000 worth of stock but now that $4000 is comprised of 100 Ginormous and 100 Teeny Tiny. Determining whether the 40 strike is in, out or at the money requires adding the dollar value of 100 Ginormous shares plus the dollar value of 100 Teeny Tiny shares.

Someone who does not realize what these options are might see the $1.50 premium, the option appearing to be seven points out of the money and only two months to expiration and sell all the naked calls he can.

Blowup.

Just remember: there is no free money in the options market.

Source: Adjusted Options: Money For Nothing?