Be sure to familiarize yourself with certain events that could trigger an adjustment to your options contracts.
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If it seems 'too good to be true', it probably is! Words to live by when trading options. Options can be confusing even under the best of circ*mstances, especially when an options contract is being "modified."
An option contract may be adjusted as a result of some type of dividend, stock distribution, stock split or similar event involving an underlying security. It is important to know when an event can lead to an adjustment of your option contract.
What is a contract adjustment?
When the terms of a stock option contract are changed to terms that differ from the original standardized terms, such as delivery (trading unit) of the contract following an underlying stock split, or corporate actions such as an acquisition, merger, or special stock or cash distribution, these terms will be adjusted to take this into account.
For underlying stock splits, there are customary standard adjustments for strike prices and trading units as necessary. For other types of underlying corporate actions, such as mergers, acquisitions, spin-offs and special distributions of cash and/or stock, adjustments are appropriate to the circ*mstances and conditions of each action and vary from situation to situation. Please note if you have or are considering an option position in a class of options for which the contract is being adjusted. Make sure you are fully aware of what the adjustments are and what financial consequences they may have for you.
Are exercise prices adjusted to take into account regular cash dividends?
No exercise price adjustments are made when an underlying stock pays a regular (e.g. quarterly) cash dividend. On the ex-dividend date, the underlying stock opens minus the dividend amount, but by then the market will generally have adjusted the prices of call and put options for this.
How do you know if an option contract has been amended?
It is important to recognize certain characteristics that may indicate that an option contract has been modified:
- It appears that the option is mispriced relative to the value of the underlying stock and the option's strike price
- The adjusted option contract will generally have lower liquidity than an unadjusted contract
- You see two calls or two puts with the same strike price but different option symbols (e.g. XYZ vs. ZYX) and different premium amounts
What events cause adjustments to option contracts?
There are certain events that can trigger an adjustment in your option contract(s): stock splits, dividends, distributions, mergers and acquisitions. When adjustments are made to an option contract, the following may change:
- Delivered
- Strike prices
- Contract multiplier
- Option symbol
Which of these conditions exactly apply is determined by the event being advertised.
When the unit of trade is adjusted, it will generally include the distribution, whatever it may be. In addition to the normal 100 underlying shares, a trading unit may contain proportionate amounts of one or a combination of the following:
- Similar shares of the same stock
- Cash amount (or cash amount).
- Shares in the underlying company of a different type (for example preference shares)
- New shares in a spin-off company or subsidiary
- Rights or warrants
- Debt participation (e.g. bonds)
Review the event definitions below and click on the event name to see an example
| Event | Definition |
|---|---|
| 2 for 1 stock split | A 2 for 1 stock split results in twice as many shares at half price. The holder of an option contract as a result of a 2 for 1 stock split will now have twice as many option contracts at half the strike price. |
| 3 for 2 stock split | A 3 for 2 stock split results in an additional 0.5 shares per share. 1 share. The share price has been reduced by 1.5. The holder of an option contract receives the same number of contracts at a lower exercise price (1.5). The contract now represents 150 shares per contract. |
| 3 for 1 stock split | A 3 for 1 stock split results in 3 times the number of shares at 1/3 of the price. The holder of an option contract receives 3 times as many contracts at 1/3 of the exercise price. |
| 4 for 3 stock split | A 4-for-3 stock split results in 1.33 times the number of shares. The share price has been reduced by 1.33. The holder of an option contract receives the same number of contracts at a lower exercise price (1.33). The option contract now represents 133 shares per contract. |
| Reverse stock split | A reverse split results in a reduction in the number of shares outstanding and an increase in the price of the underlying asset. The holder of an option contract receives the same number of contracts with an increase in the strike price based on the reverse split value. The option contract now represents a reduced number of shares based on the value of the reverse stock split. |
| Other things | Other examples of stock events that would lead to an adjustment of option contracts are mergers, acquisitions and spin-offs. |
| Special cash dividend | A special cash dividend falls outside the usual policy of being paid on a quarterly basis. Provided a dividend is special, the value of the dividend must be at least $12.50 per share. option contract, after which an adjustment to the contract will take place. |
| Special stock dividend | A special stock dividend is a dividend payment in shares for cash. The holder of an option contract receives the same number of contracts at a lower exercise price. The option contract now represents the original stock value plus the stock dividend. |
Keep in mind that companies will use different names for the payment of stock or cash to shareholders for different reasons. For example, calling a payment a dividend rather than a distribution or a spin-off could have different tax consequences for both the issuing company and the shareholder receiving the payment. For an option investor, the name of the payment is not as important as whether contract adjustments are made. Whenever you see an announcement about a special stock dividend, special cash dividend, distribution or spin-off from a company you have an option on, look for contract adjustments.
When Should You Consider Exercise Options?
When underlying companies make periodic, ordinary dividend payments to their shareholders, contractual adjustments are generally not made. In these cases, call option holders typically must exercise their call and purchase the underlying stock to qualify for the payment.
When adjustments are made, it is generally not necessary to make a call to qualify for payments such as special dividends, distributions, spin-offs and the like. These assets are generally 'linked' to the custom trading unit of the call option and are distributed through the exercise/assignment process.
Check your contracts
If you suspect that an option contract has been adjusted, you can take advantage of thisthe option chainto confirm the details. Or go to the OCC website and search by symbol.
Now you better understand how the statement "if it seems too good to be true, it probably is" applies to options contract adjustments and events that could affect your options contracts. Know your means to identify the adjustments and, as always, contact your Fidelity representative for more information.
