Stock split & dividend adjustments

Stock splits and dividends are utilized by common stock issuers to (legally) manipulate stock prices. Here’s a quick summary:

Forward stock splits

• More shares outstanding
• Market price declines proportionately

Here’s a quick example:

An investor holds the following position:

100 ABC shares at $500

If the issuer performs a 5:1 forward stock split, the position becomes:

500 ABC shares at $100

This video further discusses forward stock splits:

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Reverse stock splits

• Fewer shares outstanding
• Market price rises proportionately

Here’s a quick example:

An investor holds the following position:

100 XYZ shares at $5

If the issuer performs a 1:10 reverse stock split, the position becomes:

10 XYZ shares at $50

This video further discusses reverse stock splits:

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Stock dividends

• More shares outstanding
• Market price declines proportionately

Here’s a quick example:

An investor holds the following position:

100 BCD shares at $200

If the issuer performs a 25% stock dividend, the position becomes:

125 BCD shares at $160

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Now that we’ve covered the information above, let’s discuss how stock splits and dividends impact options contracts.

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 split type. 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, we can utilize something called the “stock split factor.” 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 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.

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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 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 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 something called 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.

*A cash dividend represents issuer profits that are distributed to shareholders. Large, well-established companies with long histories of profitability typically pay cash dividends.

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)

Sidenote

Exercise & cash dividends

A test question may ask if an investor will receive a cash dividend once a contract is exercised. Many stocks that options are traded on pay ongoing dividends. For example, let’s assume ABC Company declares a dividend to be paid in the future. If an investor is long an ABC call and exercises the contract, will they receive the dividend? It depends on the timing of the dividend and exercise.

Before we dive into this concept, we must understand the four dates surrounding a cash dividend distribution:

• Declaration date
• Ex-dividend date
• Record date
• Payable date

The declaration date is when the issuer publicly announces a dividend distribution. The ex-dividend date is the first day the stock begins trading without the dividend. The record date is when an investor must maintain a settled long position to receive the dividend. The payable date is when the cash dividend is paid.

Here’s an example of a cash dividend announcement made by an issuer:

On September 20th, 2023, the board of directors of Target Corporation (Ticker: TGT) declared a quarterly dividend of $1.10 per common share. The dividend is payable December 10, 2023 to shareholders of record at the close of business November 15, 2023.

September 20th is the declaration date, November 15th is the record date, and December 10th is the payable date. The only date not mentioned is the ex-dividend date, which is directly tied to the record date. November 15th, 2023 (the record date) was a Wednesday. Stocks maintain a T+1 (trade date plus one business day) settlement timeframe. An investor must purchase the stock by Tuesday, November 14th to settle by Wednesday, November 15th and receive the dividend. Therefore, the ex-dividend date is Wednesday, November 15th. The “ex-date” (as the industry calls it) is the first day an investor would buy the stock and not receive the dividend*. If an investor purchased the stock on Wednesday, November 15th, the trade would not settle until Thursday, November 16th, and they would not receive the dividend (because it’s one day after the record date).

*Alternatively, the ex-date is also the first day an investor holding the stock could sell the position and still receive the dividend.

The same concept applies to contract exercises. As we discussed in a previous chapter, a T+1 settlement applies to exercises of equity (stock) options. Using the same dividend scenario above, let’s assume an investor holds a long TGT call. If the investor wants to exercise the contract and receive the cash dividend, they must exercise it by Tuesday, November 14th. The stock would be bought on the exercise date and the trade would settle on the record date (November 15th). If the investor waited until or after the ex-date (November 15th) to exercise, they would not receive the dividend.

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
• ‘Buying’ contracts (long calls/short puts) must be exercised 1 business day before ex-date to receive cash dividend