ExxonMobil (XOM) bought XTO Energy Inc. (XTO) this morning to bolster its position in the natural gas market. The deal was all-stock, and it was for a 25% premium from Friday’s closing prices. XTO shareholders will receive 0.7098 common shares of XOM for each of their XTO shares. This is different than a cash deal, where XTO shareholders would have gotten a fixed dollar price for their shares. Instead, the value of their XTO stake will fluctuate with the price of the XOM stock.
So what does this deal mean for the XTO options? Well, since it is a stock deal, volatility of XTO stock will most likely mimic that of XOM, which is considerably lower. If you own XTO calls, you get the benefit of the big rally from the premium in the deal. However, your calls may lose value because of the decline in implied volatility. If you keep everything else (strike, stock price, dividends, interest rates) equal, options with higher implied volatilities have higher prices than those with lower implied volatilities. After the deal closes (which may take six months or more for regulatory approval), the options actually will settle into XOM stock.
This is where the duration and strikes you have in your portfolio really matter. If you have short-dated options that were at-the-money or in-the-money at the close on Friday, December 11, 2009, you made money from Friday’s close. For example, if you owned the XTO December 43 calls, these went from $0.15 to at least $6.10 from Friday’s close to this morning’s opening with the stock trading at $49.10 (you could sell stock and exercise calls). That is a price increase of more than 3900%. That is not bad. There is a good chance the people who own these options bought them for more than $0.15, but they most likely still had a gain in the position.
However, if you owned the XTO January 2011 55 calls that closed Friday at about $2.40, you are going to be less happy. The stock opened around $49, but the calls are bid $2.4 and asked $3.0. This means if you had to sell the bid, for this example, you would only break even on these options (and even have a chance of losing money on the options). Luckily, the deal was for stock. If it was for cash, implied volatility can go closer to 0 (since the options will settle into cash once the deal closes), which would have made those calls huge losers for people who own them. For example, with XTO at 49 and those calls trading around a 10 volatility, they most likely would be trading below $.5.
There are a lot of corner cases in these stock deals that are too complicated to get into, but investors should at least be aware. For example, what if another company comes in to bid higher for XTO in the coming weeks? What if XOM walked away from the deal? What if the deal was for part cash and part stock? This gives you the idea of the complexity in risk arbitrage situations. If you are a retail investor, there is one thing I would not do, and that is try to outsmart the experts on valuations after the deal is announced. There are firms that only trade these situations. They are experts in both the underlying deal and in how the options will react to different scenarios. You should tread very carefully in the options when these situations arise.
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