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.

Forward stock splits

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.

Even stock splits

An even stock split is easy to spot: the split ratio ends in 1. For example:

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

With even stock splits:

• The number of contracts changes.
• The strike price changes.
• The shares delivered at exercise (per contract) stays 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, use the stock split factor we learned previously.

• Find the factor: divide the first number by the second number.
  • Factor = 2/1 = 2
• Adjust the number of contracts: multiply contracts by the factor.
  • 1 contract × 2 = 2 contracts
• Adjust the strike price: divide the strike price by the factor.
  • $200 ÷ 2 = $100

So the investor goes from 1 long $200 call to 2 long $100 calls.

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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?

Uneven stock splits

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

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

With uneven stock splits:

• The number of contracts stays the same.
• The strike price changes.
• The shares delivered at exercise (per contract) changes.

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.

• Find the factor: 3/2 = 1.5
• Adjust the strike price: $90 ÷ 1.5 = $60
• Adjust the shares delivered at exercise: 100 × 1.5 = 150 shares

So the investor keeps 1 contract, but it becomes a $60 put covering 150 shares.

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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?

Reverse stock splits

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.

• Find the factor: 1/4 = 0.25
• Adjust the strike price: $10 ÷ 0.25 = $40
• Adjust the shares delivered at exercise: 100 × 0.25 = 25 shares

So the investor keeps 1 contract, but it becomes a $40 put covering 25 shares.

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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?

Stock dividends

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:

• 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)

First, determine the stock dividend factor.

• Convert the dividend to a decimal: 10% = 0.1
• Add it to 1: 1 + 0.1 = 1.1

Then apply the factor:

• Adjust the strike price: $55 ÷ 1.1 = $50
• Adjust the shares delivered at exercise: 100 × 1.1 = 110 shares

So the investor keeps 1 contract, but it becomes a $50 call covering 110 shares.

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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?

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)