An investor who owns call options on a stock that splits will wind up owning more options on the stock. However, having a larger number of options won’t increase the value of the options. That’s because the price of the underlying stock will be decreased when the stock splits. The change in stock price is directly related to the number of new shares that will be issued in the split. A 2-for-1 split would reduce the value of a $10 per share stock to $5 per share. There are other share-related events that can affect options. Consider working with a financial advisor as you pursue trading in options or other types of derivatives.
Understanding Stock Splits
When a stock splits, existing shareholders get additional shares. For instance, if a corporation declares a 2-for-1 split, an investor holding 100 shares would then hold 200 shares. To account for stock splits, the price of shares affected by splits is adjusted. For instance, if a stock trading at $10 is split two for one, the price would drop to $5.
To account for stock splits, the price of shares affected by splits is adjusted. For instance, if a stock trading at $10 is split 2 for 1, the price would drop to $5.
Understanding Options and Stock Splits
For example, a call option is a contract that gives the holder the right but not the obligation to buy a stock at a certain price per share, which is known as the strike price. Put options give the holder the right to sell a stock at a set strike price. The option contract also specifies an expiration date. Each option issued normally covers 100 shares of a stock.
A call option becomes more valuable if the price of the shares it covers rises above the strike price. If the market price of the shares falls below the strike price, the option becomes less valuable. For instance, a call option giving an investor the right to buy a company’s shares at $5 becomes more valuable if the shares rise to $10. A call option with a strike price lower than the trading price is in the money. It’s worth the difference between the strike price and trading price.
A call option with a strike price below the trading price is out of the money. It may still have some value until the expiration date. If a call option is out of the money on the expiration date, it is worthless. Put options work the other way. They are in the money when the trading price is below the strike price.
When stock splits are declared, the resulting drop in the shares’ price could affect the value of call options on the stock held by investors. To avoid this, any options contracts that are affected by a split are adjusted so they don’t lose value.
Stock splits are not the only reason options contracts may be automatically adjusted. Option adjustments may happen after reverse stock splits, mergers, acquisitions and spinoffs. The declaration of special dividends, whether of cash or stock, can also trigger adjustments.
Most options adjustments for stock splits are straightforward. For instance, if an investor has an option for 100 shares of stock with a strike price of $10, after an adjustment for a 2 for 1 split, the investor will hold two options. Each option represents 100 shares with a strike price of $5. The adjustment is done automatically by the Options Clearing Corporation (OCC), a derivatives clearinghouse. Investors don’t have to do anything to keep the value of their options unaffected.
Corporations may also declare other splits, such as 3 for 1 or 5 for 1. These work similarly. For instance, the holder of a call option on 100 shares of a stock with a strike price of $30 would, after a 3 for 1 split, own three options. Each call option would cover 100 shares with a strike price of $10.
For some splits, it is more complicated. Corporations may, for instance, declare splits of 3 for 2. If this happens an option holder will still have the same number of contracts. However, each contract will be for 150 shares of stock instead of 100. The strike price will also be reduced so the value of the option contract is the same. A 4-for-3 split would result in each contract covering 133 shares. After a 5-for-2 split, each contract would represent 250 shares.
Reverse splits reduce the number of outstanding shares. After a reverse split, the price of the affected shares increases. For instance, a 1-for-2 reverse split would result in shareholders owning half as many shares, each worth twice as much. When options contracts are adjusted to reflect reverse splits, each contract represents a smaller number of shares with a higher strike price. An option for 100 shares at $10 would, after a 1-for-2 reverse split, cover 50 shares at a $20 strike price.
So the answer to the headline question (“What Happens to Options When a Stock Splits?”) is: not much. After a stock splits, share prices are adjusted to keep the value of the total number of outstanding shares unchanged. That could cause the value of options on affected shares to change dramatically. To avoid that, options – whether call or put – on stocks that split are adjusted so that the split doesn’t change the value of the options. The option contract adjustments are handled automatically by the options clearinghouse.
Tips on Investing
Trading options can expose investors to significant losses. Experienced and qualified financial advisors can help investors manage their risk and still meet financial goals. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
Use this asset allocation tool as you weigh your risk tolerance against various combinations of large-cap, mid-cap and small-cap shares.
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