What happens when you own an option contract and the underlying stock splits or pays a dividend? How does this affect the value of options that you own? These are important questions to know before trading options on a stock that may split or declare a dividend prior to your option contract’s expiration date, or you closing out the position.
Stock Splits and Options
When stocks split, the Options Clearing Corporation (OCC) will adjust your options contract so that you do not lose money on the transition. In other words, once the split is complete, you will have essentially the same dollar amount worth of options that you had prior to the split. The way they do this is to split your contracts in a fashion proportional to the stock split.
As an example, lets say you own 10 call contracts on a stock that is currently trading at $40.90 in the market. The strike price on your contracts is $40, the expiration is next month, and the options have a current market value of $3.50 in the market.
If the stock does a 2 for 1 stock split, it will drop in value to $20.45 the next day. That doesn’t make your options worthless. What happens is the OCC will automatically convert your 10 call contracts at a strike price of $40 to 20 contracts with a strike of $20. The contract price will be adjusted to $1.75. The expiration date will remain unchanged. So, you still have $3,500 worth of call contracts after the split is complete.
While the value of your options remained the same during the process of the stock split, you need to be aware that price movements in the underlying stock post-split will have a different affect on your options than they would have pre-split. If the stock falls $1 when it is trading at $20.45, that will have a bigger impact on options prices than if it falls $1 whet it is at $40.90, assuming that the Delta remained the same through the split. This, along with the possibility of paying more commission for selling 20 contracts than you would have for selling 10, are important considerations.
Stock Dividends and Options
Much like stock splits, the effect of dividend payments on the owner of an option is important to understand. Most of the time, option prices are not adjusted to reflect dividends. (Sometimes they are adjusted for unusually large dividends.) Since dividends do affect stock prices, but options are not adjusted, this can change the value of your options by quite a bit. The effects of the dividend will be opposite for calls and puts.
From the time the dividend is declared until the ex-dividend date, the stock is likely to inch up in the market to reflect that owners prior to the ex-dividend date will be entitled to the dividend. This will increase the intrinsic value of calls, and decrease the intrinsic value of puts. On the ex-dividend date, the stock will fall in value to reflect the fact that new buyers of the stock will no longer be entitled to the dividend. At this point, call options will fall in intrinsic value and puts will rise.
As you can see, stock splits and dividends can both have a strong effect on the price of options contracts. Understanding what to expect beforehand is very important. If you are a novice options trader, we typically recommend that you avoid trading contracts on stocks that may split or declare dividends during the time you intend to own them.