If you have noticed that the number of option contracts you own on a stock that has recently split has changed, don’t panic.
When a stock splits, due to a corporate action, several components of an option contract can change to make you whole.
The adjustment calculation that is used by exchanges will depend on the type of stock split that takes place.
There are several reasons why a company determines splits its stock, but before we discuss these reasons and the calculations that are used to make option investors whole, we will briefly discuss some options basics.
What is an Option Contract?
There are two types of options, call options and put options.
- A call option is a right, but not the obligation, to purchase shares of a stock at a specific price on or before a certain date.
- A put option is the right, but not the obligation to sell shares of a stock at a specific price on or before a certain date.
The price where the option buyer and seller will exchange shares is called the strike price. Each option has a certain time horizon or tenor when it expires which is referred to as the expiration date.
If you decide to purchase or sell shares using your option you are exercising the option.
The cost to purchase an option, whether it’s a put or a call is referred to as the option premium. The most you can lose on any trade as an option buyer is the value of the option premium.
An option seller, on the other hand, could lose an infinite amount on the call side and with puts you could theoretically lose the entire amount of stock value if it goes to zero.
Each stock option provides the option buyer with the right to purchase 100-shares of the underlying stock.
For example, if you purchase 10-contracts of the ABC $200 (strike price) January 2021 calls, you have to right to purchase 2,000 shares of ABC at $200 on or before the expiration date in January of 2021.
What is a Stock Split?
When you purchase or sell an option contract, it is based on the price of the underlying stock, as well as the strike price, and the expiration date.
When a stock splits, some of those variables change, which alters the value of the option contract.
A forward stock split occurs when a company determines that it is in the shareholder’s best interest to increase the number of outstanding shares, without changing the market capitalization of the company.
For example, as the price of Apple accelerated toward $500 per share, the board of directors of Apple voted to split the shares.
The Apple board voted to split the shares 4 to 1. This means that for each share of Apple stock you own on the record date of August 24, you would receive 3-additional shares.
Additionally, the price of the stock will split. The price will be divided by 4, so the market capitalization of the company will remain the same.
Apple decided to split the shares to allow more retail investors to purchase shares of the company. The board believed that at a price close to $500 a share many investors who wanted to buy shares could not afford them.
What Happens to an Option Contract When a Stock Splits?
When a company splits its stock, like Apple, there is an impact on the value of an option contract. The result will depend on the type of split that occurs.
There are several parts of the contract that might need to be modified including:
- The Number of Contracts
- The Contracts Multiplier (normally 100)
- The Strike Price
- The Ticker Symbol
On a 4 to 1 stock split, the number of contracts would increase by 4-times, and the strike price would be divided by 4.
In the case of Apple, which completes its split on August 31, 2020, if you owned 10-contracts of a December $500 call, the result of the split would increase the number of contracts to 40, while reducing the strike price to $125.
The number of contracts will change on all splits where you can receive a whole number of option contracts. But what happens when you can’t such as when there is a 3-2 split?
On a 3 for 2 stock split, there is a change to the contract multiplier. Instead of receiving additional contracts, the option multiplier will change from 100 to another number.
In the case of a 3-2 split, you would receive 50% more shares for every one share you own.
The stock price is reduced by 1.5. You will retain the same number of option contracts with a reduced strike price and a higher multiplier. The contract will now represent 150 shares per contract.
On a reverse split, where the number of shares is reduced and the price of the stock rises, an option contract will also be altered.
Since you cannot reduce the number of contracts below one when a reverse split occurs, the multiplier will change to reflect the reduction in the number of shares you have, and the strike price will increase reflecting the higher price of the stock.
Additionally, when a corporate action creates a reverse split, the ticker symbol will change adding a number to the ticker to reflect the split.
You generally cannot purchase the new (reverse split) option, but you can sell it or exercise the option.
The upshot is that when a company announces a stock split, whether it’s a forward split or a reverse split, the corporate action will impact option contracts.
When a forward split is announced, there are several parts of the option contract that will be altered based on the type of split that is announced.
If the number of contracts can be increased by a whole number, you will receive more options contracts at a reduced strike price.
If the number of contracts cannot be increased by a whole number, the contract multiplier will increase as the strike price declines.
On a reverse split, the multiplier will be changed since you cannot receive less than 1-contract. Additionally, on a reverse split, the ticker might change.
What is important to understand is that the value of the stock, as well as the value of your options, will not change due to the stock split.
Credit: Warrior Trading