Stock splits and options – Option Trading FAQ

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Stock splits and options

Q: I own options on a stock that has just declared a 2 for 1 stock split. What happens to my options?

A: Your options will need to undergo an adjustment. Instead of covering for 100 shares, your options will now cover 200 shares but the exercise price is cut to half. This adjustment is performed automatically by the Options Clearing Corporation. In general, adjustments are made for options whenever there is a stock dividend, stock distribution or stock split.

Example

Before a 2 to 1 stock split, an investor holds a call option covering 100 shares of XYZ stock with a strike price of $50. After the adjustment, he will hold two call options with strike price of $25.

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What Happens to an Option When a Stock Splits?

Publicly traded companies may decide to split its stock for various reasons. If a company’s stock price has gone up, the price may be too high for investors to purchase shares, and a stock split lowers the price of shares making them more attractive. A stock split means that existing shareholders receive additional shares, but the value of the shares will not increase due to the stock split. When a stock split is announced, an options contract undergoes an adjustment called “being made whole.”

Key Takeaways

  • A stock split announcement means that an options contract undergoes an adjustment called “being made whole.”
  • A stock split means that existing shareholders will receive additional shares, but the value of the shares will not increase at the time of the split.
  • Similarly, a stock split will increase the total number of shares outstanding but will not increase the market capitalization of a company.

What Is a Stock Split?

“Being made whole” means the options contract is modified so that the holder is neither negatively nor positively affected by the corporate action. While a stock split adjusts the price of an option’s underlying security, the contract is adjusted so that any changes in price due to the split do not affect the value of the option. If your option is purchased post-split (that is, after the split is announced), it will not be adjusted because it already reflects the post-split price of the underlying security. The Options Clearing Corporation will automatically make these adjustments for the sake of orderly and smooth functioning markets.

Stock Split Calculations

If a company with 20 million shares announces a 2-for-1 stock split, shareholders receive one additional share of stock for each share they already own. The company’s total number of shares outstanding is now 40 million. Because of the split, the value of each share is halved. A share that was worth $16 before the split will now be worth $8.

A stock split will not increase the value of each share, but each stockholder will receive additional shares.

The “being made whole” calculation is relatively straightforward for options. Each option contract typically controls 100 shares of an underlying security at a predetermined strike price. The new share ownership is generated by taking the split ratio and multiplying by 100 while the new strike price is generated by taking the old strike price and dividing by the split ratio.

For example, if you buy a call option that controls 100 shares of XYZ with a strike price of $75. If XYZ announces a 2:1 stock split, the contract would now control 200 shares with a strike price of $37.50. On the other hand, if the stock split is 3 for 2, the option would control 150 shares with a strike price of $50.

Reverse Splits

A reverse split also reverses the adjustment process. For example, if you buy a call option that controls 100 shares of XYZ with a strike price of $5. If XYZ announces a 1:5 stock split, the contract would now control 20 shares with a strike price of $25.

In February 2020, the insurance giant Aflac announced that it would do a 2-for-1 split effective March 16, 2020. The company stated “improving liquidity” as the reason for the split.

Stock Splits and Market Capitalization

While a stock split increases the total number of shares outstanding, it will not increase the market capitalization of a company—the total market value of its shares. Thus, a company with 20 million shares outstanding at $20 per share has a market capitalization of $400 million. A 2-for-1 stock split means that both the stock and its price are halved, and the total market value of the company’s stock remains the same (40 million shares at $10 per share is $400 million).

Stock Option Splits

When a stock splits, call and put options are adjusted accordingly. In almost every case the Options Clearing Corporation (OCC) has provided rules and procedures so options investors are “made whole” when stocks split. This makes sense since the OCC wishes to maintain a relatively stable and dependable market in options, not a market in which options holders are left holding the bag every time that a company decides to split, spin off parts of itself, or go private.

In general, stock dividends of greater than 10% are called stock splits and result in options splits or adjustments. For example, a 100% stock dividend is the same as a 2-for-1 split. Stock dividends of 10% or less do not result in any options adjustments. Just to be clear about the notation used here, a split of 2:1 or 2-for-1 means for every 1 share before the split, after the split the holder has 2. Similarly, a reverse split of 1 for 4 or 1:4 means for every 4 pre-split shares, the holder has just 1 after the split.

What Happens When a Stock Option Splits?

A stock split may involve a simple, integral split such as 2:1 or 3:1, it may entail a slightly more complex (non-integral) split such as 3:2, or it may be a reverse split such as 1:4. When it is an integral split, the option splits the same way, and likewise the strike price. All other splits usually result in an “adjustment” to the option.

The difference between a split and an adjusted option, depends on whether the stock splits an integral number of times — say 2 for 1, in which case you get twice as many of those options for half the strike price. But if XYZ company splits 3 for 2, your XYZ 60s will be adjusted so they cover 150 shares at 40.

It’s worth reading the article in this FAQ on stock splits, which explains that the owner of record on close of business of the record date will get the split shares, and — and — that anyone purchasing at the pre-split price between that time and the actual split buys or sells shares with a “due bill” attached.

Stock Option Split Example

Now what about the options trader during this interval? He or she does have to be slightly cautious, and know if he is buying options on the pre-split or the post-split version; the options symbol is immediately changed once the split is announced. The options trader and the options broker need to be aware of the old and the new symbol for the option, and know which they are about to trade. In almost every case I have ever seen, when you look at the price of the option it is very obvious if you are looking at options for the pre- or post-split shares.

Now it’s time for some examples.

  • Example: XYZ Splits 2:1
    The XYZ March 60 call splits so the holder now holds 2 March 30 calls.
  • Example: XYZ Splits 3:2
    The XYZ March 60 call is adjusted so that the holder now holds one March $40 call covering 150 shares of XYZ. (The call symbol is adjusted as well.)
  • Example: ABC declares a 1:5 reverse split
    The ABC March 10 call is adjusted so the holder now holds one ABC March 50 call covering 20 shares.
  • Example: Company PQRS declares a 5% stock dividend
    As mentioned above, small stock dividends do not result in any options adjustments.

Spin-offs and buy-outs are handled similarly:

  • Example: WXY spins off 1 share of QXR for every share of WXY held.
    Immediately after the spinoff, new WXY trades for 60 and QXR trades for $40. The old WXY March 100 call is adjusted so the holder now holds one call for 100 sh WXY @ 60 plus 100 sh WXY at 40.
  • Example: XYZ is bought out by a company for $75 in cash, to holders of record as of March 3.
    Holders of XYZ 70 call options will have their option adjusted to require delivery of $75 in cash, payment to be made on the distribution date of the $75 to stockholders.

Note: Short holders of the call options find themselves in the same unenviable position that short sellers of the stock do. In this sense, the options clearing corporation’s rules place the options holders in a similar risk position, modulo the leverage of options, that is shared by shareholders.

The Options Clearing Corporation’s Adjustment Panel has authority to deviate from these guidelines and to rule on unusual events. More information concerning options is available from the Options Clearing Corporation (800-OPTIONS) and may be available from your broker in a pamphlet “Characteristics and Risks of Standardized Options.”

Article Credits:
Contributed-By: Art Kamlet

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