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 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.
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:
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.
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?
Answer = Long 5 ABC Jan $40 calls
To calculate the adjustment, utilize the stock split factor. To find the factor, divide the first stock split number (5) by the second number (1). Our stock split factor is 5 (5/1).
Next, multiply the number of contracts (1) by the stock split factor (5). The investor starts with 1 long call and ends with 5 long calls.
Last, divide the strike price ($200) by the stock split factor (5). The investor starts with 1 long $200 call and ends with 5 long $40 calls.
An uneven stock split involves a ratio that does not end in 1. For example:
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.
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?
Answer = Short 1 XYZ Sep $72 put (covering 125 shares)
We will utilize the stock split factor to calculate the adjustment. Divide the first stock split number (5) by the second number (4). Our stock split factor is 1.25 (5/4).
Next, divide the strike price ($90) by the stock split factor (1.25). The investor starts with 1 short $90 put and ends with 1 short $72 put.
Last, multiply the number of shares delivered at exercise (100) by the factor (1.25). The investor starts with an obligation to buy 100 shares at $90 and ends with an obligation to buy 125 shares at $72.
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 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)
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.
Let’s see if you can adjust for a 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)
We will utilize the stock split factor to calculate the adjustment. Divide the first stock split number (1) by the second number (20). Our stock split factor is 0.05 (1/20).
Next, divide the strike price ($10) by the stock split factor (0.05). The investor starts with 1 long $10 put and ends with 1 long $200 put.
Last, multiply the number of shares delivered at exercise (100) by the factor (0.05). The investor starts with a right to sell 100 shares at $10 and ends with a right to sell 5 shares at $200.
Stock dividend contract adjustments involve the same process we used for uneven forward and reverse splits. Stock dividends appear 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)
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.
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?
Answer = Short 1 ZZZ Apr $44 call (covering 125 shares)
We will utilize the stock dividend factor to calculate the adjustment. Add the stock dividend in decimal form (25% = 0.25) to the number 1. Our factor is 1.25 (1+0.25).
Next, divide the strike price ($55) by the stock dividend factor (1.25). The investor starts with 1 short $55 call and ends with 1 short $44 call.
Last, multiply the number of shares delivered at exercise (100) by the factor (1.25). The investor starts with an obligation to sell 100 shares at $55 and ends with an obligation to sell 125 shares at $44.
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