Options During a Stock Split
Have you noticed that the number of option contracts you own on a recently split stock has changed? If so, don’t panic.
A stock split (from a corporate action) leaves various parts of an option contract to change, making you whole. Adjustment calculations depend on the kind of stock split that occurs.
Multiple factors are influencing why a company determines to split its stock. Before considering these reasons and the calculations, let’s briefly go over some options basics.
What are Options Contracts?
There are two kinds of options; call options and put options.
- Put options give you the right but not obligation to sell stock shares at a specific price, either on or before a particular date.
- Call options are the right, but not the obligation, to buy stock shares within a particular price range on or before a specific date.
A strike price is a price that an option buyer and seller exchange shares. Each option has a specific time horizon or tenor when it expires; this is the expiration date.
When you buy or sell shares using your option, you are exercising the option.
Whether it’s a call or put, the cost to purchase an option refers to the option premium. Option premium value is the most you can lose on any trade as an option buyer. On the other hand, an option seller can lose any amount on the call side, and unfortunately, with put options, you could technically lose the total amount of stock value if it gets to zero.
Stock options provide the option buyer with the right to purchase 100-shares of the underlying stock. Let’s say you bought 10-contracts of the ABC $200 (strike price) of the January 2021 calls; you had the right to buy 2,000 shares of ABC at $200 on or before the expiration date in January 2021.
What is a Stock Split?
Buying or selling an option contract is based on three things: the underlying stock price, strike price, and expiration date. When stocks split, some of those variables change, altering the option contract’s value. Forward stock splits happen when companies determine that it’s in the shareholder’s best interest to increase the number of outstanding shares without changing its market capitalization.
When the price of the stock splits, the price is divided by 4, leaving the company’s market capitalization to remain precisely 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.
Option Contracts and Stock Splits
When a company splits its stock, there is an effect on an option contract’s value. Results vary depending on the split that occurs.
You may need to modify several parts of the contract, including:
- The Strike Price
- The Contracts Multiplier (usually 100)
- The Number of Contracts
- The Ticker Symbol
With a 4 to 1 stock split, the contract number increases by 4-times, and the strike price is divided by 4. The number of contracts changes on each split, receiving a whole number of option contracts. On a reverse split, you get a reduced number of shares and a higher stock price, leaving the option contract altered.
Because you cannot reduce the number of contracts below a whole number for a reverse split, the multiplier changes to reflect that reduction with the number of shares you have, and the strike price will rise, reflecting the higher stock price.
When corporate actions create a reverse split, the ticker symbol changes, adding a number to the ticker to mirror the split. You cannot purchase a new reverse split option, but you can sell or exercise the option.
The upshot happens when companies announce a stock split, either by a reverse or forward split, a corporate action impacts option contracts.
When they announce a forward split, it will alter several parts of the option contract based on the type of split announced.
If a whole number can increase the number of contracts, you will receive more options contracts at a reduced strike price. If a whole number cannot increase the number of contracts, the contract multiplier will increase as the strike price declines.
On a reverse split, the multiplier changes because you cannot hold less than 1-contract. Furthermore, with a reverse split, the ticker might change.
It would be best to understand that the stock’s value and the value of options do not change due to the stock split.