Stock split & dividend adjustments

Stock splits and stock dividends are tools common stock issuers use to (legally) change the number of shares outstanding, which in turn changes the stock’s market price.

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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Next, let’s look at how stock splits and stock dividends affect options contracts.

Forward stock splits

A forward stock split creates more outstanding shares that trade at a lower price per share. Start with this 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 (still 100 shares per contract)

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 2:1 stock split?

Answer: Long 2 ABC Jan $100 calls

To calculate the adjustment, use the stock split factor:

• Divide the first split number by the second: $2/1=2$. The factor is 2.

Then apply the factor:

• Contracts: multiply by the factor: $1\times 2=2$
• Strike price: divide by the factor: $200/2=100$

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Try the same process. 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 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:

• Factor = $3/2=1.5$

Then apply the factor:

• Strike price: divide by the factor: $90/1.5=60$
• Shares delivered: multiply by the factor: $100\times 1.5=150$

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Try an uneven split adjustment. 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 creates fewer outstanding shares that trade at a higher price per share. Option contract adjustments are handled the same way as uneven forward splits.

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 1:4 reverse stock split?

Answer: Long 1 MNO Dec $40 put (covering 25 shares)

Use the stock split factor:

• Factor = $1/4=0.25$

Then apply the factor:

• Strike price: divide by the factor: $10/0.25=40$
• Shares delivered: multiply by the factor: $100\times 0.25=25$

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Let’s see if you can adjust for a reverse split. 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 we 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 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, find the stock dividend factor:

• Convert the dividend to a decimal and add 1: $1+0.10=1.1$

Then apply the factor:

• Strike price: divide by the factor: $55/1.1=50$
• Shares delivered: multiply by the factor: $100\times 1.1=110$

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Try a stock dividend adjustment. 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 whether an investor will receive a cash dividend after exercising a contract. Many stocks that options are traded on pay ongoing dividends. For example, 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 the exercise.

To answer these questions, you need to know the four key dates in 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 purchases the stock on Wednesday, November 15th (the ex-date), the trade settles on Thursday, November 16th (the record date), and they do not receive the dividend.

*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 timing concept applies to option 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, 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.