Options Stock Splits
Part 41
 
The key to understanding options stock splits is that the stock split cannot change the total value of the company and therefore cannot change the total value of your position. If it did, companies could create unlimited value by continually splitting their stock which doesn’t make any more sense than you being able to create infinite wealth by continually splitting ten dollar bills into two fives.
 
The key to understanding how stock splits affect your options is to understand that if a stock split cannot change the total value of the stock then it cannot change the total exercise value of your options.
 
Let’s now see how various stock splits will affect your option contracts. Assume you own one $180 call option that is trading for $6. If the stock does a 2:1 split, the split ratio is 2/1 = 2. You will then control twice as many contracts, or two for this example. The strike price will be reduced to $180/2 = $90. In addition, the price of the option will be $6/2 = $3. Your options are packaged a little differently but the total exercise value is the same. You are controlling $18,000 worth of stock before and after the split. In addition, the value of your options is $600 before and after the split.
 
If the stock does a 3:1 split, the split ratio is 3/1 = 3. You then own three times as many calls. The strike is $180/3 = $60 and you still control $18,000 worth of stock. The price of the option will drop to $6/3 = $2 and the value of your options is still $600.
 
Now let’s look at how fractional splits affect your option contracts. Recall that fractional splits are anywhere the split ratios have a last digit greater than one, such as 3:2 and 5:4, and 8:7 for example. Fractional splits affect options in a similar way as the whole number splits we just reviewed. However, they create a small problem because the number of shares is not increased in units of 100. To alleviate the problem, the exchanges decided to adjust the number of shares each contract controls.
 
For instance, if you own one $180 call trading for $6 and the stock does a 3:2 split then the split ratio is 3/2 = 1/5. After the split, you will still own one contract; however, it will now control 150 shares of stock and the strike price will be $180/1.5 = $120. After the split, you still control 150 shares * $120 = $18,000. In this case, the “multiplier” is increased to 150 since that is how many shares the option controls. The option’s price will fall to $6/1.5 = $4. So if you see this option quoted at $4, you must remember to multiply it by 150 to find its total value.
 
If the stock does a 5:4 split then the split ratio is 5/4 = 1.2. After the split, you will own one contract that controls 100 * 1.2 = 120 shares with a strike price of $180/1.2 = $150 and you will still control 120 * $150 = $18,000 worth of stock. The option’s price would fall to $6/1.2 = $5. All options, calls and puts, are adjusted in the same way. In addition, all short positions are adjusted in the same way as the long positions. After all, the short position is simply on the other side of the trade from the long position.
 
 
For any “whole number” split (2:1, 3:1, 4:1 etc.) the number of contracts you own increases by the split ratio. The multiplier stays the same.
 
For any “fractional” split, (3:2, 5:4, 8:7, etc.) the number of contracts stays the same but the number of shares it controls is multiplied by the split ratio.
 
The market price of the stock, the strike price of your option, and the market value of the option are always reduced (divided) by the split ratio regardless of the type of split.
 
The following chart may help you to see the differences. Notice that the procedures for the strike price and market price are the same regardless of the type of split.
 
Market Adjustments
Whole Number Splits (2:1, 3:1, etc.)
Odd Number Splits (3:2, 5:4, etc.)
# Contracts
Increased by split ratio
Remains same
Strike
Reduced by split ratio
Reduced by split ratio
Stock price
Reduced by split ratio
Reduced by split ratio
Multiplier
Remains same
Increased by split ratio
 
 
Reverse Splits
There is another type of split called a reverse split, which is done for the opposite reasons of a stock split. Companies whose share price is very low may vote for a reverse split to lift the price in hopes of getting it “recognized” as a viable investment. Many times this is done so that the company meets certain listing requirements in order to trade on a nationally recognized exchange.
 
Reverse splits are most often seen in the penny stocks or other troubled stocks looking for a boost in price (and hopefully awareness). Because of this, you will rarely see reverse splits on optionable stocks since they must be above $10 to meet listing requirements to trade options. However, they can occur. If they do, the math previously described works exactly the same way but in the reverse direction.
 
For example, assume that XYZ is trading for $4. The company may vote for a 1:3 reverse split. The split ratio is then 1/3 = 0.33. This just means that shareholders will receive one share for every three they currently own and the price will rise by a factor of three. If you own 300 shares today, you have $1,200 worth of stock. After the split, you’ll have 300 * 0.33 = 100 shares after the split. The stock price will rise to $4/0.33 = $12. Once again, this doesn’t affect any the value of your position because the value of your position will still be $1,200 after the split.
 
Let’s see how the reverse split would affect your option contracts. Assume you own 20 XYZ $10 calls trading for $1 and the company announces a 1:5 reverse split. The split ratio is 1/5 = 0.20. The number of contracts you own is now 20 * 0.2 = 4 and the strike price is increased to $10/0.20 = $50. The price of the option rises to $1/0.2 = $5. Let’s check the math to make sure we got the right answer. The original position was worth $1 * 20 contracts * 100 shares per contract = $2,000 and had an exercise value of $10 * 20 contracts * 100 shares per contracts = $20,000. After the split, it is worth $5 * 4 contracts * 100 shares per contract = $2,000 and the exercise value is 4 contracts * $50 * 100 shares per contract = $20,000. Nothing has changed; only the packaging.
 
Whenever an option undergoes an adjustment, you’ll probably see a notation stating “adjusted option” or “adj opt” while placing the trade. You may see this in the final “readback” screen where you verify the order before sending it, or you may see it next to the symbol when looking up symbols. Whenever you see this notation, be sure to check the number of shares it controls.
 
For example, when we get to strategies, we will talk about the “covered call” where we will buy 100 shares of stock and then sell one call controlling 100 shares. If you inadvertently sell a call that controls 150 shares rather than 100 there could be potential problems if the stock price rises substantially. That’s because you own 100 shares but may have to deliver 150 shares if the stock’s price rises above the strike. In essence, you would be short 50 shares of stock.
 
Just as you should develop habits of checking option symbols when entering orders, you should also check to see if the total cost of the trade is roughly what you think it should be before sending the order. For example, assume you are placing an order to buy one ABC $50 call trading for $4. If you place an order to buy one contract and the computer tells you the estimated cost of the trade is more than $600 including commissions, you should realize that something isn’t right. One contract at $4 should cost $400 plus commissions, so the $600 price is obviously too high. Assuming you entered the right quantity (one contract) you can be sure this discrepancy is a sign that you’re dealing with an option that controls 150 shares.
 
 
To be continued…….
 
 
 

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