The standard (known as “plain vanilla” or unadjusted) stock option requires the delivery of shares of the underlying stock, and nothing else; no cash, no shares of another company, etc. The standard contract calls for the delivery of 100 shares of the underlying stock; this number is the multiplier.
However, the terms of stock options can be adjusted by a panel that includes the Options Clearing Corporation (OCC) and representatives of the options exchanges. Adjusted stock options are non-standard option. Adjustments are made upon a number of different events, such as stock splits, reverse stock splits, large dividends, mergers, spin-offs and other corporate events.
The goal of adjustments is to insure that option sellers and holders stay as close as possible to the relative economic positions they occupied before the event.
Non-standard call options can require the delivery of a different number of shares, delivery of shares of stock of more than one company, or delivery of underlying shares and cash; put options require non-standard purchases.
The creativity of corporate deal-doers is almost limitless, and option adjustments must take deal terms into account; thus we see some very odd adjustments on occasion. Here are the option’s terms that can be affected by adjustment (expiration is never changed):
- Multiplier – the number of shares deliverable or purchasable per contract
- Option Symbol
- Strike Price – this is where odd strikes (ex: $13.25) come from
- Number of Contracts – yes, this can change as well
- Deliverables– cash, issuer shares and shares of another issuer could be deliverable
Corporate Events Requiring Adjustment – and What Changes
The causes for adjustments to the terms of standard option contracts are numerous. The following table illustrates the effects of various common “corporate events” such as mergers, stock splits and the like. There is no need to memorize this table (we haven’t), but be aware of the process OCC uses to keep the adjustments fair to all parties.
Figure 2.9
| Table: Option Adjustments for Corporate Events | |||||||
| Event | Size/ Type | Symbol Changes | Strike Changes | # Contracts Changes | Multiplier Changes | Cash Paid | Stock of Another Issuer Deliverable |
| Stock split – even | 2 for 1 3 for 1 4 for 1 5 for 1 | No No No No | Yes;▼ Yes;▼ Yes;▼ Yes;▼ | No No No No | No No No No | No No No No | No No No No |
| Stock split – odd, with cash 1 | 3 for 2 4 for 3 5 for 4 5 for 5 7 for 5 | Yes Yes Yes Yes | Yes;▼ Yes;▼ Yes;▼ Yes;▼ Yes;▼ | Yes;▲ Yes;▲ Yes;▲ Yes;▲ Yes;▲ | Yes;▲ Yes;▲ Yes;▲ Yes;▲ Yes;▲ | No No No No No | No No No No No |
| Reverse stock split | 1 for 2 1 for 5 1 for 7 1 for 10 1 for 20 1 for 50 1 for 100 | Yes Yes Yes Yes Yes Yes Yes | Yes;▼ Yes;▼ Yes;▼ Yes;▼ Yes;▼ Yes;▼ | Yes;▲ Yes;▲ Yes;▲ Yes;▲ Yes;▲ Yes;▲ | No No No No No No No | No No No No No No No | No No No No No No No |
| Stock dividend | All | Yes | Yes;▼ | Yes;▲ | Yes;▲ | No | No |
| Ordinary cash dividend 2 | Doesn’t matter | No | No | No | No | No | No |
| Extraordinary cash dividend 3 | < $12.50/k > $12.50/k | No No | Yes | No Yes;▼ | Maybe | ||
| Merger, stock | Acquirer Acquiree | Maybe Yes | No No | No Yes | No No | Maybe | Maybe |
| Rights offering | Yes | No | Yes;▲ | No | No | No | |
| Spin-off | Yes | No | Yes;▲ | No | Maybe | Yes | |
| Stock symbol or co. name change | Maybe | No | No | No | No | No | |
| 1 Odd stock splits most always come with cash to take care of odd dollar amounts resulting. 2 Paid on a quarterly or other regular basis, irrespective of amount. 3 Not paid on a regular basis. “K” means contract. | |||||||
As you can see, the only corporate event that affects none of the contract terms is the ordinary cash dividend. Stock splits (so-called forward splits) increase the number of shares outstanding by splitting them into a greater number of shares.
A simple example is the 2:1 (2-for-1) split in which the shares are doubled: 100 shares would turn into 200 shares. A split may involve a simple, integral (even) split such as 2:1 or 3:1 (holders get two or three shares for every share they own), or it may involve a non-integral (odd) split such as 3:2 (holders get 3 shares for every two they own).
Stock Split – Even
When a split is an even one, the option splits the same way as the underlying stock, and likewise the strike price – only the strike price and number of contracts are adjusted. Thus in a 2:1 split you would get twice as many of those options at half the strike price; a $50- strike option would turn into two $25 options, but the symbols would not change.
If you had written 10 of such a contract, you would be short 20 contracts following the adjustment. The even stock split seems to be the only event in which additional contracts are issued.
Strike Changes | Additional Contracts Issued
Stock Split – Odd
However, an odd split can indeed create odd strikes. If a 3:1 split occurred, then you would receive three times the number of contracts (two additional contracts are issued for every open contract) and the strike prices would be divided by three and rounded up or down to the nearest 1/8th (ex: 55 strike becomes 18-3/8) and there would be no symbol change.
The odd splits usually result in a symbol change and an “adjustment” in the price and the number or shares deliverable. For example, if BUMM splits 3-for-2 (3:2), your BUMM $90 options will be adjusted so they cover 150 shares at $60, and the symbol will change.
Strike Changes | Symbol Changes | Multiplier Changes
Stock Split – Odd w/Cash Fraction
Odd splits with a cash fraction paid out are handled differently. The symbol changes, but not the strike or multiplier, and cash is deliverable. Symbol Changes | Cash Delivered
Reverse Stock Split
In a reverse stock split (combination) the number of shares outstanding is reduced by combining them into a smaller number of shares.
Thus in a 1:4 (1-for-4) reverse split, every four shares owned by a shareholder would be combined into only one share, and one who owns 100 of those shares would see them turn into only 25 shares.
In reverse splits the strike price does not change, but the symbol and multiplier do. If hypothetical stock BUMM undergoes a 1:4 reverse split, the strikes would remain the same but the symbols would change and only 25 shares would be deliverable.
Symbol Changes | Multiplier Changes Stock Dividends
The dividend, whether in cash or in stock, generally results in option adjustment only if it exceeds 10% of the stock’s value (cash) or it would increase outstanding shares more than 10% (stock). If adjustment occurs for a cash dividend, the option strike price will be reduced by the cash dividend’s amount. However, in practice special dividends of even $1.00 or so seem to result in strike price adjustment. For example, a 2006 Saks dividend of $4.00 per share reduced the strike price by the same $4.00. Yet a 2007 OPWV $1.20 cash dividend required the delivery of an extra $120.00 per contract, no strike change.
Strike Changes
A stock dividend greater than 10% is viewed as a stock split. For example, a 10% stock dividend, in which one new share is issued for every 10 shares then outstanding, is in effect an 11:10 split. If adjustment occurs for a cash dividend, the option strike price will be reduced by the dividend’s amount and the symbols will change. If adjustment is required it is handled the same as for a stock split.
Merger, Stock
In a typical merger, the corporation being acquired (disappearing company) merges into the acquiring company; this is the “merger of equals” scenario. Options of the disappearing company usually require, after the merger’s effective date, delivery or purchase of shares of the buyer, possibly with a cash amount thrown in.
Symbol Changes | Multiplier May Change | Stock of Another Issuer May Be Deliverable | Cash May Also Be Required
Merger, Cash-Out
In a cash-out merger, stockholders in the disappearing company receive only cash, thus only a cash amount is due from (to) the call writer (put writer) when assigned. A variant is the election merger in which shareholders of the disappearing company can elect whether they want shares or cash, as in the 2006 Veritas/DGC merger. In such a case, cash is deliverable in lieu of shares. Cash Delivered
Spin-Off of Subsidiary
A spin-off occurs when one corporation owns all or part of another (a subsidiary) and distributes to its shareholders all or part of the subsidiary shares owned. Options on the company making the distribution require the delivery or purchase of shares of the distributing company and shares of the subsidiary being spun off.
Symbol Changes | Stock of Another Issuer Is Deliverable
Tender Offer
Options are not adjusted to reflect a cash tender offer (buy out) even though the tender offer may have a favorable or negative effect on the stock being tendered for, on the theory that neither strike price nor the multiplier (number of shares deliverable per contract) are changed. Many times the tender is only a partial one, usually in a self-tender in which the corporation is tendering for its own shares. The same should hold true of management-led buyouts.
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