Contract Adjustments for Special Situations

12/20/2013 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Option expert Alan Ellman of TheBlueCollarInvestor.com details how to adjust option positions in the event of a stock split or a company spin-off.

Options trading basics includes the fact that one options contract incorporates 100 shares of the underlying security. The right or the obligation is for the purchase or sale of 100 shares of stock or exchange-traded funds. This is the rule, but there are exceptions to this rule. From time to time, a certain event will take place that will alter the terms of an equity options contract, making it different from the original standardized terms such as the number of deliverable shares.

Let’s first list some of the most common events that lead to contract adjustments:

  • Stock Splits
  • Mergers
  • Acquisitions
  • Takeovers
  • Spin-Offs
  • Special One-Time Dividends

In this article, I will highlight an example of a stock split and a spin-off.

Stock Split Example

  • Buy 100 shares of BCI @ $205
  • Sell one contract @ $210 strike @ $530 ($5.30 per share)
  • Initial one-month return on option = 2.6% (31% annualized)
  • Upside potential (to $210 strike) = 2.4%
  • Total possible one-month return = 5%
  • Stock splits 3-for-1 prior to expiration

Next let’s view a pre- and post-split comparison of this trade:

chart
Click to Enlarge

In this situation, the number of shares owned and contracts sold tripled as the strike and cost basis is cut in third. The terms of the original contract has changed but both buyers and sellers are “made whole” with this adjustment.

Spin-Off Example

  • Buy 100 x Ingersoll-Rand Plc (IR) @$72
  • Sell a one-month $72.50 call
  • A part of the company is spun off called Allegion (ALLE)
  • The price of IR drops from $72 to $55
  • For each share of IR owned, 1/3 share of ALLE is distributed + cash (.3333 x price of ALLE)
  • The original contracts of underlying IR are now recognized as having underlying IR1 where:
  • IR = IR1 = Current value of 100 x IR price + value of 33 shares of ALLE + .3333 x current value of  ALLE
  • 100 shares of IR1 are deliverable but you need a calculator to figure out if the contracts will be exercised

Here is a screenshot showing the explanation of the adjustment:

chart
Click to Enlarge

Next is a screen shot showing the contract adjustments with strikes staying the same but a new underlying called IR1:

chart
Click to Enlarge

To determine the likelihood of exercise, the holder needs to add the value of the newly priced IR shares + 1/3 the value of ALLE + .3333 x the value of ALLE. If that total exceeds the strike of $72.50, exercise will occur. Okay, time to summarize because I’m getting a headache from all of this:

Summary
Rarely, an event, like a stock split or spin-off, will take place that will necessitate the need for option contract adjustments so that buyers and sellers are “made whole.” Each situation is different so that we cannot put all changes into the same formula. When this occurs, the best track to take is to call your broker and ask for a detailed explanation. Your broker will probably not know this information initially but will have the resources to get it for you. If we know of such an event in advance (except for a split) it is generally best, not to write calls on these stocks until the event has passed and options are again standardized…it will avoid the headache I alluded to before.

By Alan Ellman of TheBlueCollarInvestor.com

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