Steve:Here is a good one for you: Let's say you go out and write an in-the-money covered call today on AWE for a year out. And let's say the deal goes through and AWE stops trading. What happens to the option and the premium you received? --J.L.

You're right, that is a good one. The first thing to note is that immediately after

AT&T Wireless

(AWE)

accepted the $41 billion, or $15-a-share, bid by

Cingular

, which is a joint venture of

BellSouth

(BLS)

and

SBC Communications

(SBC)

, all AT&T Wireless call options with a strike of $15 or above -- even those with a year remaining -- became essentially worthless. This obviously tells us that nobody expects AT&T Wireless to ever trade above $15.

This makes perfect sense: Because the terms of the takeover are set, there won't be any additional bidding, and the $15 price tag is more than most predicted. As the deal is all-cash, as opposed to a stock swap, its value will not change. This is why the implied volatilities and time premium have been removed from all of the options. This phenomenon, known as a "vega crush," was referred to in an

earlier article on mergers.

As a comparison, look at the price action and implied volatilities regarding

Comcast's

(CMCSK)

recent takeover bid for

Disney

(DIS) - Get Report

, which consisted of an all-stock offering and thus far has been rejected. The options in both companies have not only retained appropriate time values but have seen increased implied volatility levels.

But there is a difference between an agreement and actually closing the deal. Completing the AT&T Wireless takeover is expected to take anywhere from six months to a year. During that time, a number of obstacles could arise, such as regulatory clearance or some substantive change in the business that could force the deal to fall through. This helps explain why AWE shares have been trading around $13.80, or a $1.20 discount to what they ultimately will be worth.

A look at put options in AT&T Wireless lets us better gauge the market's perception of risk. Currently, the $12.50 puts are trading at about 15 cents for the April series and around 30 cents for the January 2005 expiration. All strikes below $12.50, regardless of the amount of time remaining, are essentially worthless right now. Just as the calls showed us that nobody is coming in and paying more than $15 a share, the put options indicate that there is little fear of this deal falling through. And even if did, the belief is that someone else, such as

Vodafone

(VOD) - Get Report

, would return and be set to pay at least $12.30 a share.

Dealing more specifically with the reader's question, we need to look at some in-the-money options. On Thursday, with AT&T Wireless trading at $13.80, you could sell the January 2005 call with a $12.50 strike for about $2 a contract. This gives you an implied sale price of $14.50, and a break-even, or protection, down to $10.50 a share.

On the surface, it appears that you could establish a buy-write (buy AWE shares at $13.80 and sell the calls), and simply wait until the deal closes and collect 70 cents of premium. But that works out only to an annualized return of about 0.5%. When you factor in commissions and carrying costs, most of that already-slim profit margin will be washed away.

Note that the price of in-the-money calls rises along with the time remaining to reflect the cost of holding the position. For example, the April $12.50 calls are currently priced at $1.40, giving them about 10 cents of premium. The fact that there is no free money out there is clear when you look at the $12.50 conversion (long stock, long the put, short the call) prices for each expiration month.

The one hope for collecting a relatively risk-free profit would be if the deal somehow closes several months earlier than anticipated. At that point, your stock would be worth $15, the January 2005 $12.50 calls would be worth $2.50, and the positions would offset (you'd be assigned on the short calls and have to deliver either your long shares or the cash), which would allow you to earn any price differential that may exist at that point. Your risk is that the deal collapses and AWE falls below $10.50.

For more information on what happens to options after a merger, stock split or spinoff occurs, please see this

previous article. It actually cites both AT&T Wireless and Comcast as examples, because both have undergone a variety of each over the last few years. And here's a Chicago Board of Exchange

link for both general rules and specific situations.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.