Option Investor
Trader's Corner

Making Adjustments

Printer friendly version

Imagine that you were long ten contracts of Lowe's (LOW) Sept 90 calls when the underlying company announced a stock split to be effective Tuesday, May 9. Each contract of those calls represented 100 shares of the underlying stock.

How many contracts will you be holding May 9? What strikes will you hold, and how many shares of stock will each contract represent?

That, of course, depends on the split. You might be surprised to learn that different rules apply to splits that result in round lots and those that don't. Round-lot splits are splits such as 2-for-1, 3-for-1, and 4-for-1, where the original number of stock shares held is multiplied by some integer such as 2, 3, or 4. Lowe's (LOW) split was a 3-for-1 stock split. If you were long ten contracts of Sept 90 calls previous to the effective date of the split, you'd have then been long 30 contracts of Sept 30 calls. Each contract would still represent 100 shares of the underlying stock.

Here's how it works in a round-lot split: the number of options contracts is multiplied by and the strike price is divided by the split factor. Thus, a 2-for-1 split would result in a doubling of the number of contracts and a halving of the strike of those contracts, a 3-for-1 split would result in a tripling of the number of contracts and the reduction of the strike price held by a third.

If instead of holding Sept 90 calls, you'd been holding June 100 calls when the 3-for-1 split occurred, a bit of a problem would occur. Those long ten contracts of June 100 calls would find themselves holding 30 contracts of 33-3/8 strike calls. The 100 strike is divided by three, with the resultant number rounded to the nearest one-eighth. New symbology is needed, and such new symbology was employed in Lowe's split, with the resultant June 33-3/8 calls now labeled LTRFX.

A different methodology is employed when a split does not result in a round lot of shares. For example, when Gerdau S.A. (GGB) announced a 3-for-2 ADS split with an ex-date for the split of Friday, April 21, the split was not a round-lot split. Someone long ten contracts May 25 calls would be long ten contracts of May 16-5/8 calls after that ex-date, with each contract representing 150 shares of the underlying. Here's how it works when the split is not a round-lot split: the number of contracts would not change, but the strike and the number of underlying shares represented by each contract would. To determine the new strike price, the original strike would be divided by the split ratio (3/2 or 1.5) and the contract unit would be multiplied by that same split ratio.

Whenever a split is announced, the option exchange that trades those options publishes the details of the options terms. In the previous two cases, the CBOE trades those options, and the details were located under the "Trading Tools" section of the site. If the Philadelphia Stock Exchange traded the options, as it does the LOW options, the information would be published there, with such information found under the "Mergers and Corporation Actions" portion of the site.

Splits aren't the only corporate actions that may cause an adjustment in options contracts. As of this writing, The Sports Authority, Inc. (TSA) was slated to merge with Leonard Green & Partners. As long as the merger goes forth as planned, the published adjustment on www.phlx.com states that "all outstanding TSA options will be adjusted as follows . . . $3,725.00 cash per contract ($37.25 x 100)."

Other adjustments may be different, according to the terms of a merger or acquisition, and sometimes they can be quite complex. Those conditions are always published, however, on the site of the exchange trading the options. So, if you should wake up one morning and find that the underlying company on which you hold options is being acquired, watch for the information to be published.

How soon will that happen? On March 31, TSA announced a convening of a special stockholders meeting May 2 to consider the acquisition. That day, news announcements by the company referred interested parties to the SEC and TSA sites (www.sec.gov and www.sportsauthority.com) for the definitive proxy statement which was to be filed. Also on that day, the company made available on its site form DEFM14A it filed, suggesting the treatment of stock options if the merger were to be accomplished. An unofficial summary of TSA's options adjustments was first published on the CBOE site April 17 with the merger being approved at the May 2 stockholder's meeting. Those holding TSA options were advised well ahead of that meeting what the terms will be.

If news mentions a merger, go the company's website for such filings, usually posted on the "Investor Relations" portion of the site, and then watch the exchanges for up-to-date and definitive statements.

Stock splits are handled in a routine manner, as described above, but mergers and acquisitions vary. While news on mergers and acquisitions may appear first on company websites, the exchanges provide you with the necessary information on both.

Trader's Corner Archives