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How do options work with stock splits


I own options on a stock, and it's just announced a split. What happens to my options?


When the underlying stock of your option splits or even begins issuing a stock dividend, the contract undergoes an adjustment that is often referred to as "being made whole," which means the option contact is modified accordingly so that you are neither negatively nor positively affected by the corporate action. While a stock split will adjust the price of the underlying security of an option, the option is adjusted so that any changes in price due to the split do not affect the value of the option. Keep in mind that if your option is purchased post-split (i. e. after the split is announced) then your option will not be adjusted as it will have been created according to the new split price of the underlying security.


How do you calculate what the new option will be worth? Well, you typically don't need to worry about such things because the Options Clearing Corporation will automatically do it for you (for the sake of orderly and smooth markets). But if you are wondering how it's done, the calculation is relatively straightforward. Each option contract is typically in control of 100 shares of an underlying security at a predetermined strike price. To find the new coverage of the option, take the split ratio and multiply by the old coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio. Say, for example, you own a call for 100 shares of XYZ with a strike price of $75. Now, if XYZ had a stock split of 2 for 1, then the option would now be for 200 shares with a strike price of $37.50. If, on the other hand, the stock split was 3 for 2, then the option would be for 150 shares with a strike price of $50.


What Happens To Options During Stock Splits.


What Happens To Options During Stock Splits - Introduction.


"What Happens To Options During Stock Splits?" This is perhaps one of the first questions beginner option traders ask shortly after option trading for real. This is an extremely important question to answer as stock splits does happen often and not knowing what's going on definitely throws every amateur options trader into disarray and confusion, leading to all the wrong actions.


What Happens To Options During Stock Splits - What Is A Stock Split?


A stock split happens when a company "splits" its shares up into smaller portions while maintaining overall share capital. A company with 10,000 shares trading at $50 can split into 20,000 shares of $25. This is what we commonly call a 2 for 1 split and which is the most common form of stock split. If you are holding shares 100 shares of that company at $50 before the split, you will end up with 200 shares of $25 after a 2 for 1 split. But what happens when you are holding options instead?


What Happens To Options During Stock Splits?


When a stock splits, the OCC or Options Clearing Corporation, automatically adjusts your options holding through your option trading broker to reflect the proportion of the split such that you too will end up with a net position value which is equivalent to before the split. If you own 1 contract of $50 strike price call options on the company mentioned above valued at $2 per contract on the day of a 2 for 1 split, you will end up with 2 contracts of $25 strike price call options valued at $1 per contract. Let's look at the net effect of the split:


This is also the same treatment if you owned employee stock options. Options that underwent such adjustments are known as Adjusted Options.


What Happens To Options During Stock Splits - The Drawback.


While this adjustment to your stock options may seem like a fair deal, it does change some things. First of all, it increases the number of options contracts that you are holding, which may or may not conform to your option trading plan. The more options contracts you are holding, the higher the real dollar loss in the short term should the stock take a ditch. Let's assume that the company's stocks fall from $25 to $24 right after the stock split.


How do stock splits work?


You might have heard about them in the financial media or they could be causing you some confusion in your personal portfolio. So we get the question a lot: How do stock splits work?


You can think of a stock split as a cake that’s been sliced into eight pieces — it’s the same delicious cake, just cut into smaller bits.


When a company splits its stock, it’s just dividing its existing shares into more, lower-priced shares. But even though the number of shares outstanding increases, nothing happens to the company’s intrinsic value.


That’s because the share price is reduced in proportion to the number of new shares issued. Double the shares, half the share price. Triple the shares, one-third the share price. You get the picture.


Let’s look at a hypothetical example …


Monkey Mittens Inc. has 100 million shares outstanding, each trading at $100. One day, the board of directors decides to implement a 2-for-1 stock split. After the split takes effect, the company will recall all 100 million shares and then issue 200 million in replacement, worth half as much ($50) each.


See why the company’s underlying value isn’t changing? The market capitalization — shares outstanding multiplied by share price — is $1 billion both before and after the split. It’s math.


What does a split mean for shareholders?


Say you own 40 shares of Monkey Mittens. Once the split takes effect … poof ! You now see 80 shares in your brokerage account! You’ve hit the jackpot, right?


Sadly, no. Your investment “cake” has just been cut into slices.


For all intents and purposes, stock splits don’t affect shareholders. Actually, they’re kind of a non-event … at least as far as you’re concerned. Even though you’ll have more shares, the price will be reduced proportionally — which means the total value of your investment won’t change .


Before the split, you owned 40 shares of Monkey Mittens, each priced at $100. Now, after the split, you own 80 shares, but each is priced at $50. Same total investment.


If you’re wondering about the tax consequences of a stock split … there are none. Since your equity doesn’t change, neither do your tax payments.


Stock splits don’t affect your total dividend payment, either. The company will probably just lower the amount it pays out per share to adjust for the increase in shares outstanding.


Why do companies split stocks?


The conventional explanation is that companies split their stock in order to attract a wider pool of shareholders. By lowering the share price, they hope to make the stock appear more affordable for your average investor.


For whatever reason, some investors target stocks priced between $20 and $100 per share. Get much above that and the shares are deemed “too expensive.” So if a company sees its share price rise above this level, it might execute a stock split to make the stock seem more affordable.


The effect is purely psychological, though — you’re not actually getting more bang for your buck. The value of the stock isn’t changing. Whether you buy 10 shares at $10 or 20 shares at $5, you’re still going to have $100 invested in the company. But for some investors, the second scenario screams bargain.


Another motivation for a company to split its stock is to increase its liquidity , AKA make people buy and sell it more often. In theory, a stock split should accomplish this by reducing the share price and increasing the number of shares on the market.


Having a highly liquid stock is good for a company’s economic growth because it reduces the risk of that stock falling prey to market manipulation through domination by one or two big traders. It’s good for you, too. When there’s a high trading volume, you can easily move out of your position … even if you own a large number of shares.


Are stock splits a buy signal?


It depends who you’re asking. There’s been a lot of research over the years about the performance of split stocks, but the results have been mixed.


One side says a stock split is a no-questions-asked buy signal. Many think it indicates that a company is doing well and that it’s expecting to keep doing well … after all, why would it create room to rise if it weren’t expecting to rise? Some just think it comes down to supply and demand principles — a stock that appears cheaper will intensify demand and thereby drive up stock price.


Critics, on the other hand, argue that stock splits don’t have any effect on a stock’s performance — after all, they don’t do anything to the company’s fundamental value. They may lead to short-term price spikes thanks to media hype and renewed investor attention, but they shouldn’t have any effect on long-term price appreciation.


The Foolish take.


Frankly, we consider stock splits to be the one of the most overrated topics in equity investing.


Investors everywhere get way too fired up about stock splits, to the point that they risk being manipulated by companies that are just trying to juice speculative buying. For some reason, many investors believe that having more shares is somehow better … and that even though many brokers allow you to buy fractions of shares, stocks with a higher price tag are “expensive.”


We’re not saying that you should totally ignore stock splits.


But short-term speculative buying based on a largely cosmetic change isn’t a sustainable investing strategy. Whenever you’re dealing with stock splits, just remember: a slice of pizza will only taste as good as the pie it came from.


— Answer provided by Motley Fool intern Caroline Jennings.


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Stock splits and options.


Q: I own options on a stock that has just declared a 2 for 1 stock split. What happens to my options?


A: Your options will need to undergo an adjustment. Instead of covering for 100 shares, your options will now cover 200 shares but the exercise price is cut to half. This adjustment is performed automatically by the Options Clearing Corporation. In general, adjustments are made for options whenever there is a stock dividend, stock distribution or stock split.


Before a 2 to 1 stock split, an investor holds a call option covering 100 shares of XYZ stock with a strike price of $50. After the adjustment, he will hold two call options with strike price of $25.


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Leverage using Calls, Not Margin Calls.


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Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]


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Valuing Common Stock using Discounted Cash Flow Analysis.


Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]


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Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.


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