Option contract
adjustments: a comprehensive guide
An option contract
is a financial derivative that gives the holder the right, but not the
obligation, to buy or sell an underlying asset, such as a stock, at a
predetermined price (the strike price) before a specified expiration date.
However, real-life events like corporate actions can influence the terms of an
option contract. These events may trigger what is known as option contract
adjustments, which ensure that option holders are neither unfairly advantaged
nor disadvantaged by corporate actions such as stock splits, dividends,
mergers, or acquisitions.
In this
comprehensive guide, we will explore the various corporate actions that can
trigger adjustments, how these adjustments are calculated, and what they mean
for traders and investors. By the end of this article, you will understand what
happens to option contracts during corporate events and why adjustments are
necessary to maintain fairness in the market.
1. Why option
adjustments occur
Corporate
actions—events initiated by a company that affect its stock—have the potential
to alter the underlying value of the shares tied to an option contract. Since
option pricing is largely based on the value of the underlying asset, these
corporate events must be accounted for so that option holders are not unduly
impacted by stock price changes resulting from events that are not reflective
of market sentiment or company performance.
Adjustments ensure
that both parties in an options contract maintain the same economic position
they held before the corporate action took place.
2. Types of corporate
actions that trigger adjustments
The most common
corporate actions that lead to option contract adjustments are:
Stock Splits
Reverse Stock Splits
Dividends (especially Special Dividends)
Mergers and acquisitions
Spinoffs
Each of these
corporate actions can change the price or the number of shares of the
underlying stock, and thus affect the terms of the associated option contracts.
3. Stock splits
A stock split
increases the number of shares outstanding by issuing more shares to current
shareholders. For example, in a 2-for-1 stock split, each shareholder receives
two shares for every one share they own, but the total value of their
investment remains unchanged because the stock price is halved.
Impact on option contracts:
When a stock split
occurs, the strike price of the option is reduced proportionally, and the
number of contracts or shares underlying the options is increased. This ensures
the contract's total value remains the same. Here's how the adjustments work:
Strike price adjustment:
The strike price is divided by the stock
split ratio.
Number of shares adjustment:
The number of shares per contract
(typically 100) is multiplied by the split ratio.
Example:
Imagine you hold a
call option on a stock with a strike price of $50, and the company announces a
2-for-1 stock split. After the split:
The new strike price will be Rs.25 (Rs.50 ÷ 2).
The number of shares per contract will double from 100 to
200.
In this case, the total value of your position remains
unchanged.
4. Reverse stock splits
A reverse stock
split is the opposite of a stock split. In this case, a company reduces the
number of shares outstanding, which increases the price per share. For example,
in a 1-for-2 reverse stock split, every two shares are combined into one,
doubling the stock price while halving the number of shares outstanding.
Impact on option contracts:
Strike Price
Adjustment: The strike price is
multiplied by the reverse split ratio.
Number of shares adjustment:
The number of shares per contract is
divided by the split ratio.
Example:
If you hold a call option with a strike price of Rs.50 and
the company undergoes a 1-for-2 reverse stock split, the new strike price will
be Rs.100 (Rs.50 × 2), and the number of shares per contract will be reduced
from 100 to 50.
Again, the total value of your position remains unchanged,
preserving fairness for the option holder.
5. Special dividends
While regular
dividends are anticipated and factored into option pricing models, special dividends—which
are unexpected or unusually large—can significantly alter the value of an
option contract. Since dividends generally reduce the price of a stock, a
special dividend can cause a sudden drop in the underlying stock price, which
can adversely affect option holders.
Impact on option contracts:
When a company
announces a special dividend, an adjustment is often made to the strike price
of the option to reflect the reduced value of the stock. The strike price is
typically reduced by the dividend amount to account for the dividend payout.
Example:
Suppose you own a call option with a strike price of Rs.50,
and the company declares a special dividend of Rs.5 per share. After the
dividend, the strike price of the option will be reduced to Rs.45 (Rs.50 – Rs.5).
This adjustment ensures that the option holder is not penalized by the sudden
decrease in the stock price due to the dividend.
6. Mergers and acquisitions
When one company acquires another or merges with it, the
underlying shares of the target company are typically replaced by either cash,
stock in the acquiring company, or a combination of both. In such cases, the
option contracts on the acquired company's stock may require complex
adjustments.
Impact on option contracts:
Cash-for-stock mergers:
If the merger is a cash deal (e.g., the
acquiring company buys the target's shares for cash), the option contract may
be adjusted into a cash-settled option. This means the option holder will
receive cash for the value of their option at expiration rather than shares of
the new company.
Stock-for-stock mergers:
In a stock-for-stock merger, option
holders may have their contracts adjusted to represent the acquiring company's
shares instead of the original company's shares.
Example:
If Company A
acquires Company B and offers 0.5 shares of Company A for each share of Company
B, the option contracts on Company B's stock will be adjusted to represent 0.5
shares of Company A for every 1 contract.
7. Spinoffs
A spinoff occurs
when a company splits off a portion of its business into a separate,
independent entity. This corporate action can affect the stock price of the
parent company, as the spun-off business is no longer part of the parent.
Impact on option contracts:
When a spinoff
occurs, adjustments are made to ensure the option holder has the same economic
exposure to both the parent company and the new company. Typically, the option
is adjusted to cover both the parent and the spun-off company's shares.
Example:
If a company
undergoes a spinoff where shareholders receive shares in the new company, the
option contract may be adjusted to reflect the right to acquire shares in both
companies under a single contract.
8. How adjustments
are implemented
The Options
Clearing Corporation (OCC) oversees the implementation of option contract
adjustments in the U.S. market. The OCC issues adjustment notices whenever a
corporate event triggers a change to option contracts. These notices detail how
the strike price, number of shares, or other terms of the contract are
modified.
Once an adjustment
is made, the option contract becomes what is known as a non-standard option,
meaning its terms differ from the standard contracts (which typically cover 100
shares of stock). Non-standard options can still be traded, but their pricing
and liquidity may differ from standard contracts.
9. Why option
adjustments matter
Understanding how
and why options are adjusted is crucial for traders and investors, particularly
those who hold long-term positions or trade around corporate events.
Adjustments ensure fairness in the market by maintaining the economic
equivalence of an option contract before and after a corporate action.
Without adjustments, one party in the contract could benefit
disproportionately from changes in the underlying stock's value, leading to
market inefficiencies and potential losses for one side.
Conclusion
Option contract
adjustments are a vital mechanism in the options market that preserve fairness
when corporate actions affect the underlying stock. Stock splits, reverse
splits, special dividends, mergers, acquisitions, and spinoffs all trigger
adjustments that modify strike prices, the number of shares, or the type of
settlement. By understanding these adjustments, traders can make informed
decisions and avoid surprises when corporate events impact their option
positions.
This knowledge is
especially important for active traders who may find themselves holding options
through corporate actions, as well as long-term investors who use options as
part of their broader investment strategy.
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