What happens to options when a stock splits?

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Stock distribution graph

An investor who holds call options on a dividing stock will end up owning more options on the stock. However, having more options will not increase the value of the options. This is because the price of the underlying stock will fall when the stock divides. The variation in the share price is directly linked to the number of new shares that will be issued during the demerger. A 2-to-1 split would reduce the value of a share from $ 10 per share to $ 5 per share. There are other events related to actions that can affect options. Consider working with a Financial Advisor when you continue to trade options or other types of derivatives.

Understanding stock splits

When an action divides, shareholders get additional actions. For example, if a company declares a 2-to-1 split, then an investor with 100 shares will own 200 shares. To account for stock splits, the price of the shares affected by the splits is adjusted. For example, if a stock traded at $ 10 is split two-for-one, the price would drop to $ 5.

To account for stock splits, the price of the shares affected by the stock splits is adjusted. For example, if a stock traded at $ 10 is split 2 to 1, the price would drop to $ 5.

Understand options and stock splits

For example, a call option is a contract that gives its holder the right but not the obligation to buy a share at a certain price per share, called the strike price. Put options give their holder the right to sell a share at a defined strike price. The option contract also specifies an expiration date. Each option issued normally covers 100 shares of one share.

A call option becomes more valuable if the price of the shares it covers exceeds the strike price. If the market price of the shares falls below the strike price, the option loses its value. For example, a call option giving an investor the right to buy shares of a company at $ 5 becomes more valuable if the shares rise to $ 10. A call option with an exercise price lower than the trade price is in the money. This is worth the difference between the strike price and the trade price.

A call option with an exercise price lower than the trade price is out of the money. It may still have a certain 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 around. They are in the money when the trade price is lower than the strike price.

When stock splits are declared, the resulting decline in stock price could affect the value of stock call options held by investors. To avoid this, all option contracts affected by a split are adjusted so that they do not lose value.

Stock splits aren’t the only reason option contracts can be automatically adjusted. Option adjustments may occur after reverse stock consolidations, mergers, acquisitions and spinoffs. The declaration of special dividends, whether in cash or in shares, may also trigger adjustments.

Adjustment mechanics

Currency behind the green book

Currency behind the green book

Most option adjustments for stock splits are simple. For example, if an investor has one option for 100 stocks with an exercise price of $ 10, after an adjustment for a 2-to-1 split, the investor will hold two options. Each option represents 100 shares with an exercise price of $ 5. The adjustment is made automatically by the Option clearing company (OCC), a derivatives clearinghouse. Investors do not have to do anything to ensure that the value of their options is not affected.

Companies can also report other divisions, such as 3 to 1 or 5 to 1. These work the same way. For example, the holder of an option to buy 100 shares of a stock with an exercise price of $ 30, after a 3-to-1 split, would have three options. Each call option would cover 100 shares with an exercise price of $ 10.

For some splits, it’s more complicated. Companies can, for example, declare divisions of 3 to 2. If this happens, an option holder will always have the same number of contracts. However, each contract will be for 150 shares instead of 100. The strike price will also be reduced so that the value of the option contract is the same. A split of 4 to 3 would result in each contract covering 133 shares. After a 5 to 2 split, each contract would represent 250 shares.

Reverse splits reduce the number of shares outstanding. After a reverse split, the price of the affected shares increases. For example, a reverse 1 to 2 split would cause shareholders to own half as many shares, each worth twice as much. When option contracts are adjusted to reflect reverse splits, each contract represents a smaller number of shares with a higher strike price. A 100-stock option at $ 10 would cover, after a 1-for-2 split, 50 stocks at an exercise price of $ 20.

Final result

So the answer to the main question (“What happens to options when a stock splits?”) Is: not much. After a stock split, stock prices are adjusted to keep the value of the total number of shares outstanding unchanged. This could lead to a drastic change in the value of the options on the shares concerned. To avoid this, options – whether call or put – on dividing stocks are adjusted so that the split does not change the value of the options. Adjustments to option contracts are managed automatically by the options clearinghouse.

Tips for investing

  • Trading options can expose investors to significant losses. Experienced and qualified financial advisers can help investors manage their risk while achieving their financial goals. The free tool of SmartAsset connects you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you reach your financial goals, start now.

  • Use this asset allocation tool when you assess your risk tolerance for various combinations of large, mid and small cap stocks.

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