What happens to options when a stock splits? After a company sees a significant increase in its stock price, some will consider a stock split to keep the per-share price at a range where more buyers will have the ability to buy shares. Some trading platforms still provide access to nearly any company with fractional share sales. A stock split increases the shares in circulation, but the current shareholders will receive a proportional number of shares to the number they hold.
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So What Happens During Stock Splits?
What happens to options when a stock splits? A similar process happens to any options contracts that are outstanding and this is called “being made whole.” The particular stock split announcement will determine the option’s “being made whole” adjustment. In the simple case, we have one call option for a stock that’s trading at $100/share and our option is for 100 shares at $102/share.
There’s an announced 2-for-1 stock split (the split ratio), for every outstanding share, the holder will receive an additional share. The company’s market capitalization doesn’t go up. In general, when a 2-for-1 split happens, the value of the stock will go down by half. For every share owned, the shareowner starts with one share worth $100 per share. After the split, they now have two shares worth $50 per share.
How Do Stock Splits Affect Options?
What happens to options when a stock splits? With options the “being made whole” calculation is nearly as straightforward. A typical option’s contract, like our example, is for 100 shares of the security, at its determined strike price of $102/share with the defined expiration date with a 2-for-1 split.
To make this whole, the option contract will take the split ratio and multiply it by 100. We go from one contract to two contracts of 100 shares; so 200 shares can be purchased with our example.
At the same time, the new strike price is found by dividing the old strike price by the split ratio 2-for-1, so the strike price will drop from $102 to $51/share.
What happens to options when a stock splits? If there’s an uneven stock split, for example, a 5-for-2 or 3-for-2, the call option “make whole” adjustments are handled differently. Traders cannot hold a fractional option contract; which would be the result of a contract being adjusted in a 5 for 2 or 3-for-2 ratio.
If there’ been a 3-for-2 split we would see the contract jump from 100 to 150 shares (rather than 1.5 contracts for 100 shares), and our strike price would be $68/share. The date of the expiration for the option will remain the same.
How Do Stock Splits Affect Options?
When you hold options and a stock split happens, you’re supposed to end up in an equal position as you started. We assume through the math that this is a fair deal. However, if you’re holding call options, you will potentially be looking at higher commissions for welling a larger number of contracts.
Additionally, since you’re holding more contracts, your options trading plan may not fit this number. The more options contracts you hold, the losses can be amplified if there’s a price decline.
Since the share price drops due to a split, a $1 change in the underlying stock value will have a larger proportional change on the call option’s value.
The reduction in stock price may change the human perceived support and resistance levels. In the human mind, $50 may not be the same or as important as $100 even if mathematically they are.
Options and Reverse Stock Splits
A similar process happens with a reverse split. If you have a call contract and there is a 1:4 reverse split, then the number of shares for your contract will decrease from 100 to 25 shares; and the strike price will also be multiplied by 4. With our $102 call, the strike price would now increase to $408/share.
In this case, we’ll potentially save on commissions. Ad the single dollar movement of a price won’t feel as mentally important. So the $400 level may not “feel” as important as a $100 level. Perception is a reality many times.
Have the Options Been Adjusted for the Split?
- The option appears mispriced. Check the string; if all calls and puts in all strikes are different, the adjustment has occurred having mispriced options for an entire class is rare.
- Two root symbols share the same strike price. Sometimes, an adjusted contract appears with a standard one; when looking at a string of option prices for the same stock, check if all the symbols are identical. These should have the same strike price but different option root symbols. The price differences between these two contracts may vary significantly.
What happens to options when a stock splits? Once you know the basics understanding options and stock splits are easy. Just make sure to do the math right, and as always, don’t put at risk more than you’re comfortable with. Options are a great way to grow a small account. But you have to be smart with it. Good luck with all your trades.