Occasionally, stock-specific events will affect the value of your option contract. Perhaps the most common of these is the quarterly dividend payment -- but stock splits, reverse splits, mergers, and even bankruptcies can all impact an existing option trade.
Keep reading to find out what you can expect, and how to manage your trade, when you're faced with option contract adjustments. And to stay current on all of the latest option contract adjustments that might affect your trades, pay a visit to the official website of the Options Clearing Corporation (OCC).
Dividends
These aren't technically "adjustments," as regularly scheduled quarterly dividends will be priced into your option contract before you even buy it. Because the stock price is widely predicted to drop by the amount of the dividend on the ex-dividend date, affected call options will discount the amount of the payout, while put premiums will rise by a comparable amount. In other words: all other things being equal, a scheduled dividend payment translates into cheaper call options and more expensive put options. If you keep this in mind before you buy or sell, regular dividend payments shouldn't create too much drama in your options trading.
However, it's a different story when a special dividend is announced after you've already bought or sold an option. Most frequently, the strike price of your option will be adjusted lower to reflect the amount of the special dividend. For example, a one-time cash payment of $5 could turn your 25-strike call into a 20-strike call. While this development may have a relatively muted impact on option buyers, it could result in option sellers being unexpectedly assigned.
Stock Splits
Each option contract is typically based on 100 shares of the underlying stock -- so what happens when that stock splits? In a traditional 2-for-1 split scenario, a stock's value might decline from $100 per share to $50 per share. If you're holding two 100-strike call options, your position could be adjusted by the OCC to include four 50-strike call options. While the strike price and number of contracts has changed, the net value of the position remains the same.
Alternately, the strike price might remain the same while the underlying asset is changed. For example, in a 3-for-2 split, the deliverable may change from 100 shares per contract to 150 shares per contract. The exact nature of the adjustment may vary from case to case.
A reverse stock split is simply a mirror-image scenario. Assume a $10 stock undergoes a 1-for-2 split and is now trading at $20. If you were holding two 10-strike calls, your position might be adjusted to include one 20-strike call. Again, as with traditional stock splits, the deliverable itself may also be altered to reflect the change to the stock's price (50 shares per contract instead of 100, for example).
Of course, the math won't always be so tidy in real-life scenarios. Thankfully, the OCC handles the nitty-gritty details of these contract adjustments, and detailed memos are posted to their site to keep investors informed of the latest changes.
Mergers and Acquisitions
If you own options in a company that's being acquired, there are a few possible outcomes. If your option is out of the money, and the stock is staying close to its acquisition price, your contract(s) will likely expire worthless when the options cease trading (which coincides with the completion date of the buyout). In this case, you could liquidate your position to capture the remaining time value, if any -- or, you could simply chalk up the trade as a loss and leave it to expire worthless.
In the case of an in-the-money option, you have a few choices. Typically, an acquisition deal means shareholders will receive a fixed amount of cash and/or stock in exchange for their shares. Upon closing, your option contract will be worth an equivalent amount of cash and/or stock, which you may collect when the options stop trading. Or, prior to the merger date, you could sell to close your contract(s) to lock in any gains on the trade, if that's your preference. This second route might also be a good choice if you're eligible to receive stock, but would rather not be a shareholder in the acquiring company.
Delisting
If a stock is delisted because it's not meeting exchange standards for minimum share price or trading volume, option activity on the shares may have already dried up. After the delisting announcement is made public, however, traders may continue to buy and sell options in any existing series until the stock officially gets the boot. Once the stock's listing is removed, the relevant options exchange will generally provide information on cash settlement or liquidation of any remaining contracts.
Bankruptcies
When a company files for Chapter 7 or Chapter 11 bankruptcy, trading in that stock may be halted by the listing exchange. If this occurs, options trading on that stock is simultaneously halted. If the bankrupt company then resumes over-the-counter trading, options holders will have an opportunity to close out or exercise their contracts at that time. However, no new option trades may be initiated.
KEEP READING:
- Understanding Option Pricing
- Rolling Options Out, Up, and Down
- Options Expiration, Assignment, and Exercise
FAQs
(Example: To adjust for a 2-for-1 split, divide 1 by 2. The factor is 0.5.) Just like with dividend adjustments, we multiply all historical prices prior to the split by 0.5. With splits, we also adjust the volume in the opposite direction of prices, so that the total liquidity remains the same.
Are options contracts adjusted for dividends? ›
An option contract may be adjusted due to stock dividend, stock distribution, special cash distribution, stock split, reverse stock split, rights offering, reorganization, recapitalization, reclassification, merger, consolidation, dissolution or liquidation of the underlying security.
How are options adjusted for stock splits? ›
For example, if you buy a call option that controls 100 shares of XYZ with a strike price of $75. If XYZ announces a 2:1 stock split, the contract would now control 200 shares with a strike price of $37.50. On the other hand, if the stock split is 3 for 2, the option would control 150 shares with a strike price of $50.
What are the adjustments of option contracts? ›
An adjusted option exists when the original terms of the option contract are amended. Various types of corporate actions such as, stock splits, mergers, dividends, acquisitions, spin-offs or similar events relative to the underlying may cause an option to become adjusted.
Why is it important to adjust dividends for stock splits? ›
For example, dividends provide income to shareholders, stock splits increase the number of shares held but reduce the share price proportionally, mergers and acquisitions can lead to changes in ownership or valuations, and rights or bonus issues offer opportunities for shareholders to purchase additional shares at a ...
How are dividends and stock splits accounted for? ›
In general, dividends declared after a stock split will be reduced proportionately per share to account for the increase in shares outstanding, leaving total dividend payments unaffected. The dividend payout ratio of a company shows the percentage of net income, or earnings, paid out to shareholders in dividends.
What is an example of an adjusted option? ›
In many cases, the strike price of your option may be adjusted downwards to account for the special dividend amount. For example, if a one-time special cash dividend payment of $10 is made, a call option with a $40 strike price could potentially be adjusted to a $30 strike.
When should you avoid options trading? ›
7 mistakes to avoid when trading options
- Not having a trading strategy.
- Lack of diversification.
- Lack of discipline.
- Using margin to buy options.
- Focusing on illiquid options.
- Failing to understand technical indicators.
- Not accounting for volatility.
For example, let's say you owned 10 shares of a stock trading at $100. In a 2-for-1 split, the company would give you two shares with a market-adjusted worth of $50 for every one share you own, leaving you with 20 shares.
What happens if you have options and the stock splits? ›
A standard options contract is still deliverable into 100 shares of stock. In the case of odd split, such as three-for-two or four-for-five, the number of contracts typically stays the same and the strike price is adjusted. The deliverable is adjusted as well.
Making options trading adjustments: 3 things to consider
- Treat any options trading adjustment as a new position. Map profit and loss exits as you would for any new trade.
- Match your new position with your market outlook and volatility backdrop.
- Consider carefully any adjustments that add risk to the original trade.
It's basically a draw, and the value of your investment won't change. However, investors generally react positively to stock splits, partly because these announcements signal that a company's board wants to attract investors by making the price more affordable and increasing the number of shares available.
How do you calculate option contracts? ›
Each contract is 100 shares. Options profit is calculated by subtracting the strike price and option price from the current share price and multiplying by the number of contracts (100 shares).
What is the rule of option contract? ›
An option contract is a promise to keep an offer open for another party to accept within a period of time. With an option contract, the offeror is not permitted to revoke the offer within the stated period of time. Most option contracts require consideration and other contract formalities in order to be enforceable.
How do you settle an options contract? ›
If the contract is In-The-Money (ITM) or has intrinsic value on the expiry date, the option holder gets cash settlement. However, if the options contract has no intrinsic value at expiry, it expires worthlessly. There is no cash settlement in this case.
Is the adjusted close price adjusted for both dividends and splits? ›
Therefore, an adjusted closing price will include any adjustments that need to be made to the price. The adjustments made are to compensate for anything that could've affected the stock's value, such as a corporate action. The corporate actions can include dividends or stock splits.
Should you adjust chart for dividends? ›
It's important to adjust a chart for its dividends to visualize the impact of those dividends. This is especially true for long-term shareholders. A dividend-adjusted chart shows the total return of the asset.
What is the adjustment factor for dividends? ›
For dividends the adjustment factor is calculated by subtracting the dividend from the close price the day before the ex-dividend date, and then dividing by that close price to get the adjustment factor in percentage terms.
How are share prices adjusted after dividends? ›
While the dividend history of a given stock plays a general role in its popularity, the declaration and payment of dividends also have a specific and predictable effect on market prices. After the ex-dividend date, the share price of a stock usually drops by the amount of the dividend.
