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Anatomy of a Reverse Stock Split
10/12/2020 10:00 am EST
Option contracts can be standard or adjusted. Certain corporate events may change standard option contracts to adjusted contracts, says Alan Ellman of The Blue Collar Investor.
These events include stock splits, mergers, acquisitions, special dividends, spin-offs, and reverse splits. After these events, options are altered to reflect these changes and make buyers and sellers of options whole. This article will focus in on reverse stock splits.
What is a reverse stock split?
A reverse stock split results in the reduction of outstanding shares and an increase in the price of the underlying security. The holder of an option contract will have the same number of contracts with an increase in strike price based on the reverse split value. The option contract will now represent a reduced number of shares based on the reverse stock split value.
Why corporate boards approve reverse splits
When share price declines substantially, the stock may be viewed as a low-quality investment. A reverse split increases share price for cosmetic appeal. Also, companies may fear exchange de-listing of a stock if it fails to maintain the threshold required price.
Real-life example with SPDR S&P Oil & Gas Exploration & Production ETF (XOP)
XOP Price Decline from over $100.00 to $31.00
Option Clearing Corporation (OCC) explanation for XOP 1-for4 reverse split
XOP Contract Adjustment on 3/30/2020
- Share price quadruples
- Number of shares deliverable per contract and owned is quartered
- Ticker symbol changes
Reverse splits are generally signs of weakness. These corporate events enhance the cosmetics of share price without changing to overall value of the security. Option holders and sellers are made whole by the OCC by altering one or more of the contract parameters. In the case of XOP, the number of shares were reduced by a factor of four while share price increased by that same factor. Generally, stocks that undergo reverse splits are not ideal candidates for covered-call writing and selling cash-secured puts.
Learn more about Alan Ellman on the Blue Collar Investor Website.
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