May 29, 2003

Weird Options - Stock Option Adjustments
By John Brasher, CallWriter Publisher

Ever wondered why call or put options sometimes have weird strike prices, like $46.75? Or why an option contract is exercisable for 133 shares, instead of the usual 100? Or why you exercise an option and also get shares of a second company you never heard of? These anomolies happen more often than you think, and they are due to adjustments caused by recapitalizations (spin offs, stock splits, reverse splits, etc.) and mergers. When these corporate events occur, the terms of the option contract need to be adjusted so that the writers and holders are in the same relative position after the event as before it. The strike price may be affected and sometimes the number of underlying shares deliverable, but the expiration date always remains the same.

A great example is the all-too-common stock split. If a company splits its stock 3-for-1, every shareholder of the company will get 2 new shares for every share he now owns, and the stock price will be cut by two-thirds on the split's effective date. But outstanding stock options have to be adjusted for this event as well. In this example, every option contract would turn into 3 option contracts, and the price would be cut by two-thirds.

Example:  MSFT is at $60 and decides to effect a 3-for-1 (3:1) split. On the split date, each outstanding share would become 3 shares, and the stock price would change to $20, which would be the same as the pre-split capitalization. A call option contract to purchase 100 shares at a $60 strike price ($6,000) would be changed into 3 call option contracts to purchase 100 shares at $20 (3 x 100 x $20 = $6,000).

Odd splits, such as 6:5 or 3:2, can result in really strange new strike prices. The number of shares covered by a contract can also change from the usual 100 to an odd number, such as 166 or 125. Whenever the number of share deliverable changes, the options exchange that trades the option will change the option symbol in order to differentiate it from the standard contract covering 100 shares. The proper adjustment is decided on by a joint panel of the option exchanges and the Options Clearing Corporation (OCC).

When initiating a new call position, it is wise to check that the option has not been adjusted to a non-standard number. If an option contract has been adjusted to cover more than 100 shares and you buy 100 shares to cover each contract, you would be naked on the balance deliverable over 100.

Options are not adjusted for regular cash dividends, meaning those less than 10% of the stock's price. These are considered built into the stock's price by market forces. However, adjustments are made for stock dividends. If a company declared a 1:10 stock dividend, a call writer exercising a call on that stock just prior to the ex-dividend date would receive 110 shares per contract: the regular 100 shares plus an additional 10 as a dividend. The same thing happens when a spin off occurs.

Example:  Suppose MSFT decides to spin off BeBop corporation as a separate public company. It will do this by distributing the stock of Bebop to MSFT shareholders. MSFT decides to issue 1.5 shares of BeBop for every 10 shares of MSFT held. A person exercising a MSFT option at this time would receive 100 shares of MSFT and 15 shares of Bebop.

Good luck and good trading!