Stock split & dividend adjustments

We previously discussed stock splits and stock dividends. You learned why companies pursue them and the result on security positions. When a stock split or stock dividend occurs, it also affects option positions.

Forward stock splits

Forward stock splits result in more outstanding shares trading at a lower price per share. Assume an investor starts with this position:

Long 1 ABC Jan $200 call (right to buy 100 shares @ $200)

If a forward stock split occurs, the contract is adjusted in different ways depending on the type of split. There are two types of forward splits - even and uneven.

Even stock splits

An even stock split can easily be spotted. If the stock split ratio ends in 1, then it’s an even stock split. For example:

• 2:1 stock split
• 4:1 stock split
• 10:1 stock split

Even stock splits adjust the number of contracts and strike price, but the number of shares delivered at exercise (per contract) remains the same.

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, utilize the stock split factor we learned previously. Divide the first stock split number (2) by the second number (1). Our stock split factor is 2 (2/1).

Next, multiply the number of contracts (1) by the stock split factor (2). The investor starts with 1 long call and ends with 2 long calls.

Last, divide the strike price ($200) by the stock split factor (2). The investor starts with 1 long $200 call and ends with 2 long $100 calls.

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Let’s see if you can make the same adjustments. 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?

Uneven stock splits

An uneven stock split involves a ratio that does not end in 1. For example:

• 3:2 stock split
• 5:4 stock split
• 7:2 stock split

Uneven stock splits adjust the strike price and the number of shares delivered at exercise (per contract), but the number of contracts stays the same.

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)

We will utilize the stock split factor to calculate the adjustment. Divide the first stock split number (3) by the second number (2). Our stock split factor is 1.5 (3/2).

Next, divide the strike price ($90) by the stock split factor (1.5). The investor starts with 1 short $90 put and ends with 1 short $60 put.

Last, multiply the number of shares delivered at exercise (100) by the factor (1.5). The investor starts with an obligation to buy 100 shares at $90 and ends with an obligation to buy 150 shares at $60.

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Let’s see if you can adjust for an 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?

Reverse stock splits

Reverse stock splits result in fewer outstanding shares trading at a higher price per share. Option contract adjustments are treated similarly to uneven forward splits.

Assume this new position:

Long 1 MNO Dec $10 put (right to buy 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)

We will utilize the stock split factor to calculate the adjustment. Divide the first stock split number (1) by the second number (4). Our stock split factor is 0.25 (1/4).

Next, divide the strike price ($10) by the stock split factor (0.25). The investor starts with 1 long $10 put and ends with 1 long $40 put.

Last, multiply the number of shares delivered at exercise (100) by the factor (0.25). The investor starts with a right to sell 100 shares at $10 and ends with a right to sell 25 shares at $40.

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Let’s see if you can adjust for a reverse split. Again, assume this position:

Long 1 MNO Dec $10 put (right to buy 100 shares @ $10)

What would the contract become if MNO stock was subject to a 1:20 reverse stock split?

Stock dividends

Stock dividend contract adjustments involve the same process we used for uneven forward and reverse splits. Stock dividends appear as a percentage; for example:

• 10% stock dividend
• 15% stock dividend
• 25% stock dividend

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)

Our first step is determining the stock dividend factor. Add the stock dividend in decimal form (10% = 0.1) to the number 1. Our factor is 1.1 (1+0.1).

Next, divide the strike price ($55) by the stock dividend factor (1.1). The investor starts with 1 short $55 call and ends with 1 short $50 call.

Last, multiply the number of shares delivered at exercise (100) by the factor (1.1). The investor starts with an obligation to sell 100 shares at $55 and ends with an obligation to sell 110 shares at $50.

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Let’s see if you can adjust for a 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?

Sidenote

Adjustments for cash dividends

Options are generally not adjusted if a cash dividend is paid by the underlying stock’s issuer. This is true for regular, quarterly dividends that are predictable. For example, Coca-Cola Co. (symbol:KO) has been paying consistent quarterly dividends for over 50 years. No adjustments are made to Coca-Cola options due to their predictable nature.

On the other hand, options contracts are adjusted for special dividends, which are unexpected dividend payments. These can come from stocks that pay regular dividends or those that generally don’t pay dividends.

Costco (symbol: COST) is an example of a company that pays regular quarterly dividends, but also pays a special dividend on occasion. In 2020, the company paid a quarterly dividend of $0.70 per share. At the end of the year, Costco’s Board of Directors announced a special dividend of $10 per share. While the usual quarterly dividends did not result in adjustments to Costco options, the special dividend reduced all strike prices by $10.

For example, let’s assume an investor owns this option:

1 COST Jan 550 call (covering 100 shares)

After the $10 special dividend, the option would become:

1 COST Jan 540 call (covering 100 shares)

Key points

Option contract adjustments

• Required for stock dividends or splits

Even forward stock splits

• Stock splits with a ratio ending in 1
• Option contract adjustments:
  • More contracts
  • Lower strike price
  • Same shares delivered at exercise (per contract)

Uneven forward stock splits

• Stock splits with a ratio not ending in 1
• Option contract adjustments:
  • Same number of contracts
  • Lower strike price
  • More shares delivered at exercise (per contract)

Reverse stock splits

• Option contract adjustments:
  • Same number of contracts
  • Higher strike price
  • Fewer shares delivered at exercise (per contract)

Stock dividends

• Option contract adjustments:
  • Same number of contracts
  • Lower strike price
  • More shares delivered at exercise

Cash dividends

• Options are not adjusted for regular cash dividends
• Options are adjusted for special cash dividends
  • Same number of contracts
  • Strike price reduced by the amount of dividend
  • Same shares delivered at exercise