Stock splits can significantly affect options traders. What happens to options when a stock splits? How are contracts adjusted to maintain fairness? And how do reverse splits impact options differently? Let’s explore these types of stock splits and their effects on options.
Key takeaways
- What happens to options when a stock splits is that the contracts are adjusted to maintain their value. The Options Clearing Corporation ensures smooth market functioning during splits.
- Reverse splits affect options in the opposite manner to regular splits.
What Is a Stock Split?
A stock split happens when a company increases the number of its outstanding shares by dividing its existing shares into smaller units. For example, in a 2-for-1 split, each share becomes two, effectively doubling the share count.
But here’s the key—while the number of shares grows, the company’s total market value remains the same. Instead, the price of each share decreases proportionally. So, if a stock trades at $100 before a 2-for-1 split, it would trade at $50 afterward.
Why do companies do this? Here are some common reasons:
- Make shares more affordable: High stock prices can discourage smaller investors. Splitting stocks creates lower share prices, which can attract more buyers.
- Increase liquidity: More shares at a lower price mean it’s easier for investors to buy and sell, which improves trading activity.
- Attract a broader audience: By making shares accessible to casual investors, the company can reach more potential shareholders.
Stock splits are designed to enhance a company’s appeal without altering its actual value. But what happens to options when a stock splits? We’ll tell you more in a second but, for now, just consider that your contracts will be adjusted to reflect the changes, ensuring the value remains consistent. This includes adjusting strike prices and the number of shares underlying the contract.
Understanding how stock splits—and even reverse splits—affect options is important to stay on top of your trading strategy. This helps you avoid surprises and keeps you ready to adapt to these events.
What Happens to Options When a Stock Splits?
When a company announces a stock split, it doesn’t just impact shares—it also affects options tied to the stock. This is where the concept of “being made whole” comes in. After a stock split, options contracts are adjusted to ensure their total value remains unchanged. This adjustment prevents any unfair advantage or loss for option holders.
Here’s what happens in practice:
- Strike Prices Adjust: The strike price of an option is divided by the stock split ratio. For example, let’s say you own an option found on our advanced screener. If the original strike price was $100 and the stock splits 2-for-1, the new strike price will be $50.
- Contract Volumes Change: Options are also adjusted to reflect the new share count. A standard contract that originally covered 100 shares would double to control 200 shares after a 2-for-1 split.
These adjustments ensure options remain in proportion to the new stock price and share volume without affecting the holder’s position.
If you’re buying options after a stock split, you’ll notice these changes already priced into the contracts. New options will naturally reflect the adjusted share price and volume, so there’s no need for further modifications.
Role of the Options Clearing Corporation (OCC)
The OCC plays a key role in overseeing these adjustments. It recalculates strike prices, share volumes, and other terms to maintain market stability. By standardizing these modifications, the OCC ensures fairness and prevents disruption in the trading process.
Understanding how stock split options work is crucial, especially if you’re holding or planning to trade options. Knowing that adjustments like these are automatic helps reduce uncertainty and keeps your trading strategy on track. It’s also important to remember that reverse splits have an opposite effect, consolidating shares and impacting option terms differently.
Stock Split Options – Calculating the Effects on a Split on Options
Let’s take a further step and break down how stock splits influence option contracts with simple calculations. When a stock splits, options are adjusted to ensure their value remains intact through a process called “being made whole.” Here’s how the math works.
Share Quantity Adjustments
The number of shares an options contract controls changes based on the split ratio. Multiply the original share quantity by the split ratio to determine the new volume.
Here is the general formula to apply to these adjustments:
New share quantity = Original share quantity × Split ratio
If the split ratio is 2-for-1, and the contract originally covered 100 shares:
New share quantity = 100 shares × 2 = 200 shares
For a 3-for-2 split, the calculation looks like this:
New share quantity = 100 shares × (3/2) = 150 shares
Strike Price Adjustments for Stock Split Options
The strike price adjusts in the opposite direction, as it is divided by the split ratio. Here is the formula to apply:
New strike price = Original strike price ÷ Split ratio
Using a 2-for-1 split as an example, if the original strike price was $100:
New strike price = $100 ÷ 2 = $50
For a 3-for-2 split:
New strike price = $100 ÷ (3/2) = $66.67
Examples of Split Scenarios
For a 2-for-1 split, the original contract of 100 shares at an $80 strike price becomes a new contract of 200 shares at a $40 strike price. For a 3-for-2 split, the original contract of 100 shares at a $60 strike price becomes a new contract of 150 shares at a $40 strike price.
What Happens to Call Options When a Stock Splits? And What About Puts?
The adjustments above can apply to both call and put options. In both cases, the strike price and share quantity change proportionally to the split ratio, ensuring the option holder’s position remains unaffected.
Understanding how stock split options are recalculated helps you stay informed and confident. Once you know how these adjustments work, the complexities of “what happens to options when a stock splits” become much simpler to handle!
What Happens to Options When a Stock Reverse Splits
We should also mention the case for reverse splits. A reverse stock split is the opposite of a standard stock split. Instead of increasing the number of shares, companies combine existing shares to reduce their number while increasing their price per share. For example, in a 1-for-5 reverse split, five shares would consolidate into one, and the share price would multiply by five.
Why does this happen? Mainly, this is because stock market indexes may require, for instance, a certain stock to quote at least $1.00 per share. This requires the company to consolidate its shares and bump up their price so that it can stay listed on the index.
As you may guess, a reverse split is often interpreted as a bearish signal for a company. The market will often see this move as a “desperate” act to try and raise a share price artificially, with the final goal of guaranteeing the company’s listing on a major stock exchange.
How Do Stock Splits Affect Options in Reverse Splits?
When a stock reverse splits, the associated options contracts are adjusted accordingly to maintain their value. This adjustment is essentially a reverse version of the “being made whole” process we see in regular splits:
The Share Quantity Decreases
The number of shares an option controls decreases based on the reverse split ratio. Here is the formula you would apply:
New share quantity = Original share quantity ÷ Split ratio
For instance, if a contract originally controlled 100 shares and the reverse split is 1-for-5, the new share quantity would be:
New share quantity = 100 ÷ 5 = 20 shares
The Strike Price Rises
The strike price increases proportionally to the reverse split ratio, so you’d use this formula:
New strike price = Original strike price × Split ratio
Using the same 1-for-5 example, if the original strike price was $20, the new strike price would be:
New strike price = $20 × 5 = $100
Implications for Options Traders
These adjustments are automatic, but they can introduce challenges for options holders:
- Reduced Liquidity: With fewer shares outstanding, trading activity in the stock and its options may decrease. This can make it harder to buy or sell options at favorable prices.
- Potential Value Changes: While the total value of the contract stays the same on paper, market dynamics might cause subtle shifts in pricing. For example, higher individual share prices could impact bid-ask spreads in the options market.
Role of the Options Clearing Corporation (OCC): The OCC is responsible for managing these adjustments. It updates the terms of the options, including strike prices and share quantities, and ensures everything remains standardized. This allows the market to function smoothly, even after a reverse split.
