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Stock Splits Are Back in Fashion, How Are Options Afffected?

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Stock splits used to be a fairly common occurrence, especially during bull markets. When the shares of a company appreciated to a price that might preclude a small investor from buying 100 shares, that company would “split” them by issuing a stock dividend, increasing the total number of shares outstanding.  Generally market forces would adjust the price of the shares downward to account for the dilution of the additional distribution.

The consideration of 100 shares as a “round-lot” is a vestige of the days when stock trades happened only in person on the floor of an exchange. For traders and specialists handling hundreds or thousands of individual orders at a time, round numbers were much easier to deal with than 37 of this and 156 of that. Now that the vast majority of trades are matched electronically, that’s not an important consideration anymore. Unlike a human, a computer is just as good at performing mathematical operations with messy numbers as it is with round ones.

The most common split was 2-for-1 in which existing shareholders would be issued one additional share for each share they owned (though 3:1, 4:1, 5:1 as other ratios are not unheard of.) This would double the number of shares outstanding, and those shares generally traded at half of the previous price after the split. In theory, a split doesn’t affect the value of the company as a whole and having twice as many shares trading at half the previous price results in an identical market capitalization.

In practice however, investors tend to see stock splits as a positive development that portends future share price appreciation. This isn’t totally illogical – after all, the lower price per share is intended to make a purchase more available to small investors. If it works, the net effect of new buyers in the market should push prices higher.

Part of the effect is due to intangible factors. Investors have an ingrained preference to own a greater number of shares even if the total value is the same. Also, historically, companies make the decision to enact a split when things are going well, and that can becoe a self-fulfilling prophecy.

Starting about 15 years ago, several technology stocks that saw their shares appreciate rapidly made a decision not to split their shares. Led by Alphabet (GOOG - Free Report) , share prices of high-flying tech stocks rose into the triple and quadruple digits and individual investors simply got used to the idea of buying less than 100 shares at a time.

Over the past few years as some of those technology stocks continued to climb, many brokerage houses even began to facilitate trading fractional shares so that investors could purchase less than a whole share of a stock like Amazon (AMZN - Free Report) which trades north of $3,000.

Splits are Back

Recently, two of the most popular stocks with retail investors – Apple (APPL) and Tesla (TSLA - Free Report) announced that they would be splitting their shares. Apple will split 4-for-1 and Tesla 5-to-1. Both splits will go into effect after the close of trading on August 31st. (Somewhat predictably, both companies got a significant boost in share price after their respective announcements.)

What should you do if you have an option position in a stock that announces a stock split that will occur before your options expire?

The short answer is: you generally don’t have to do anything.

Listed options contracts in the US are the province of the Options Clearing Corporation (OCC). In addition to acting as the counterparty for every long and short options trade and setting margin deposit requirements to ensure the solvency of the markets, the OCC also sets and occasionally adjusts the specifications of options contracts.

While a standard contract is for the delivery of 100 shares of the underlying stock at the strike price, the OCC will change the deliverable and/or the strike price to minimize or eliminate the financial impact of a corporate action on option values.

In the case of a stock split, it’s typically the strike that gets adjusted as well as the quantity of contracts. In the case of X-for-1 splits, the strike is divided by X and the quantity of contracts is multiplied by X, resulting in zero economic impact.

Example:

AAPL stock price: $450/share

Position: own 1 September 500 strike call

After the 4:1 split, there will be 4 times as many AAPL shares outstanding, so the strike is divided by 4 and the quantity of options is multiplied by four. A trader who owned one 500 strike call will now own four 125 strike calls.

Because for every option owner, there is a seller, the operation is identical for the writer of the 500 call. That trader is now short four 125 calls.

Other than being aware that the position will now look different, these traders don’t need to do anything to retain the economic value of their trades, the OCC takes care of all the work.

One note: in the (rare) case of splits at odd ratios - for instance, 5-for-3 – it may not be mathematically possible to completely eliminate the economic impact of the action. In these cases the OCC makes the adjustment(s) that come closest as possible to a fair outcome for all participants . For professional traders with thousands of options on their books, these instances can sometimes produce large, unexpected profits and losses. For the average retail trader, the effects are usually limited to just a few cents per option and the total impact in negligible.

If you’re ever uncertain about what’s going to happen to your options positions in the case of a stock split – or during a merger, spin-off, special dividend of cash or stock or anything else that materially changes the nature of a holding in the underlying security - the source for information is the website of the Options Clearing Corporation. www.theocc.com.

While there is likely to be no material effect on your position, it’s always a good idea to be as informed as possible about the contract specs to avoid surprises.

-Dave


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