We previously discussed stock splits and stock dividends. You learned why companies use them and how they affect stock positions. When a stock split or stock dividend occurs, it can also change the terms of existing option contracts.
A forward stock split increases the number of shares outstanding and lowers the market price per share. Start with this option position:
Long 1 ABC Jan $200 call (right to buy 100 shares @ $200)
When a forward split occurs, the option contract is adjusted. The adjustment depends on whether the split is even or uneven.
An even stock split is easy to spot: the split ratio ends in 1. For example:
With even stock splits:
Assume this position again:
Long 1 ABC Jan $200 call (right to buy 100 shares @ $200)
What would the contract become if ABC stock was subject to a 2:1 stock split?
Answer: Long 2 ABC Jan $100 calls
To calculate the adjustment, use the stock split factor we learned previously.
So the investor goes from 1 long $200 call to 2 long $100 calls.
Let’s try another even split. Again, assume this position:
Long 1 ABC Jan $200 call (right to buy 100 shares @ $200)
What would the contract become if ABC stock was subject to a 5:1 stock split?
Answer = Long 5 ABC Jan $40 calls
To calculate the adjustment, use the stock split factor.
So the investor goes from 1 long $200 call to 5 long $40 calls.
An uneven stock split uses a ratio that does not end in 1. For example:
With uneven stock splits:
Assume this new position:
Short 1 XYZ Sep $90 put (obligation to buy 100 shares @ $90)
What would the contract become if XYZ stock was subject to a 3:2 stock split?
Answer: Short 1 XYZ Sep $60 put (covering 150 shares)
Use the stock split factor to calculate the adjustment.
So the investor keeps 1 contract, but it becomes a $60 put covering 150 shares.
Now adjust for another uneven split. Again, assume this position:
Short 1 XYZ Sep $90 put (obligation to buy 100 shares @ $90)
What will the option contract become if a 5:4 stock split occurs on XYZ stock?
Answer = Short 1 XYZ Sep $72 put (covering 125 shares)
Use the stock split factor to calculate the adjustment.
So the investor keeps 1 contract, but it becomes a $72 put covering 125 shares.
A reverse stock split reduces the number of shares outstanding and raises the market price per share. Option contract adjustments are handled like uneven forward splits.
Assume this new position:
Long 1 MNO Dec $10 put (right to sell 100 shares @ $10)
What would the contract become if MNO stock was subject to a 1:4 reverse stock split?
Answer: Long 1 MNO Dec $40 put (covering 25 shares)
Use the stock split factor to calculate the adjustment.
So the investor keeps 1 contract, but it becomes a $40 put covering 25 shares.
Let’s try another reverse split. Again, assume this position:
Long 1 MNO Dec $10 put (right to sell 100 shares @ $10)
What would the contract become if MNO stock was subject to a 1:20 reverse stock split?
Answer: Long 1 MNO Dec $200 put (covering 5 shares)
Use the stock split factor to calculate the adjustment.
So the investor keeps 1 contract, but it becomes a $200 put covering 5 shares.
Stock dividend contract adjustments follow the same process used for uneven forward splits and reverse splits. Stock dividends are quoted as a percentage, for example:
Assume this new position:
Short 1 ZZZ Apr $55 call (obligation to sell 100 shares @ $55)
What would the contract become if ZZZ stock was subject to a 10% stock dividend?
Answer: Short 1 ZZZ Apr $50 call (covering 110 shares)
First, determine the stock dividend factor.
Then apply the factor:
So the investor keeps 1 contract, but it becomes a $50 call covering 110 shares.
Now try another stock dividend. Again, assume this position:
Short 1 ZZZ Apr $55 call (obligation to sell 100 shares @ $55)
What would the contract become if ZZZ stock was subject to a 25% stock dividend?
Answer = Short 1 ZZZ Apr $44 call (covering 125 shares)
Use the stock dividend factor to calculate the adjustment.
So the investor keeps 1 contract, but it becomes a $44 call covering 125 shares.
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