Dividends, Stock Splits, and Other Option Contract Adjustments

Occasionally, stock-specific events will affect the value of your option contract. Perhaps the most common of these is the quarterly dividend payment -- but stock splits, reverse splits, mergers, and even bankruptcies can all impact an existing option trade.

Keep reading to find out what you can expect, and how to manage your trade, when you're faced with option contract adjustments. And to stay current on all of the latest option contract adjustments that might affect your trades, pay a visit to the official website of the Options Clearing Corporation (OCC).

Dividends

These aren't technically "adjustments," as regularly scheduled quarterly dividends will be priced into your option contract before you even buy it. Because the stock price is widely predicted to drop by the amount of the dividend on the ex-dividend date, affected call options will discount the amount of the payout, while put premiums will rise by a comparable amount. In other words: all other things being equal, a scheduled dividend payment translates into cheaper call options and more expensive put options. If you keep this in mind before you buy or sell, regular dividend payments shouldn't create too much drama in your options trading.

However, it's a different story when a special dividend is announced after you've already bought or sold an option. Most frequently, the strike price of your option will be adjusted lower to reflect the amount of the special dividend. For example, a one-time cash payment of $5 could turn your 25-strike call into a 20-strike call. While this development may have a relatively muted impact on option buyers, it could result in option sellers being unexpectedly assigned.

Stock Splits

Each option contract is typically based on 100 shares of the underlying stock -- so what happens when that stock splits? In a traditional 2-for-1 split scenario, a stock's value might decline from $100 per share to $50 per share. If you're holding two 100-strike call options, your position could be adjusted by the OCC to include four 50-strike call options. While the strike price and number of contracts has changed, the net value of the position remains the same.

Alternately, the strike price might remain the same while the underlying asset is changed. For example, in a 3-for-2 split, the deliverable may change from 100 shares per contract to 150 shares per contract. The exact nature of the adjustment may vary from case to case.

A reverse stock split is simply a mirror-image scenario. Assume a $10 stock undergoes a 1-for-2 split and is now trading at $20. If you were holding two 10-strike calls, your position might be adjusted to include one 20-strike call. Again, as with traditional stock splits, the deliverable itself may also be altered to reflect the change to the stock's price (50 shares per contract instead of 100, for example).

Of course, the math won't always be so tidy in real-life scenarios. Thankfully, the OCC handles the nitty-gritty details of these contract adjustments, and detailed memos are posted to their site to keep investors informed of the latest changes.

Mergers and Acquisitions

If you own options in a company that's being acquired, there are a few possible outcomes. If your option is out of the money, and the stock is staying close to its acquisition price, your contract(s) will likely expire worthless when the options cease trading (which coincides with the completion date of the buyout). In this case, you could liquidate your position to capture the remaining time value, if any -- or, you could simply chalk up the trade as a loss and leave it to expire worthless.

In the case of an in-the-money option, you have a few choices. Typically, an acquisition deal means shareholders will receive a fixed amount of cash and/or stock in exchange for their shares. Upon closing, your option contract will be worth an equivalent amount of cash and/or stock, which you may collect when the options stop trading. Or, prior to the merger date, you could sell to close your contract(s) to lock in any gains on the trade, if that's your preference. This second route might also be a good choice if you're eligible to receive stock, but would rather not be a shareholder in the acquiring company.

Delisting

If a stock is delisted because it's not meeting exchange standards for minimum share price or trading volume, option activity on the shares may have already dried up. After the delisting announcement is made public, however, traders may continue to buy and sell options in any existing series until the stock officially gets the boot. Once the stock's listing is removed, the relevant options exchange will generally provide information on cash settlement or liquidation of any remaining contracts.

Bankruptcies