Stock Split Effect on Options

Topic: How do stock dividends and splits affect the stock options?

Dear Options Trading FAQ:

I have purchased calls on a stock that has announced a stock dividend of 3 for 2. I purchased the call options before the record date. I may exercise the options between the record date and the time the stock dividend is allocated.

How will this affect my options? I am not exactly sure what the difference is (if any) between a stock dividend and a stock split. In a stock dividend does the extra share for every two come from the shares held by the company? Or is it the same as a split where the number of all shares is increased and the price appropriately adjusted? Please respond soon because my options expire this Friday! Of course I could just sell the calls for a profit, but I would like to own the stock with the stock dividend.

Too Many Options, Not Enough Time

Dear 3 for 2 Split:

Let me answer in a practical sense first, then I'll go into some financial mumble jumbo. Not all the details are apparent in your example, but I suggest that you check very carefully whether "adjustments" to the option terms have been made yet. (Is the stock now trading at the "usual" price, or the post-dividend price? That's how you'll know if the options have been adjusted).

When you call to sell or exercise the option on Friday, have the rep check the account to see how the option is listed. Make sure you sell the right option.

Here's an example of how traders have been tricked in the past: In some cases, there are instances of simultaneous listings of both "old" and "new" options. e.g. if ABC splits 3:2, the outstanding options will be adjusted to new terms (lower strike price with fractional values and more underlying shares). They will then sport the ABZ option symbol to indicate the change. Then new options may be introduced with the regular ABC designation. These will trade with the usual terms (100 share multiple and usual strikes) under the regular ABC symbol.

New option buyers will go for these, but the "old" option holders may get tricked and sell the wrong option, not knowing that their option has been adjusted and now has a new symbol. A holder may call up to sell the ABC option instead. He'll then be long the ABZ and short the ABC!

Anyway, that is just something to be aware of but that will apply only in cases where the split has occurred a while ago and there are both new and adjusted options to worry about. In your case, the option has yet to be adjusted and with the expiration so close, it probably won't be. So your concern is whether to sell it outright or to exercise. Adherents to efficient market and arbitrage theory will say that on this level, it doesn't make any difference. If you exercise, you'll have stock that is entitled to the dividend, but so will any stock that is bought at any time before the payout. The premium at this point should be at parity with the intrinsic value, so there is no advantage there.

I like to tell people to just sell the options for a profit. I do so for several reasons. A stock split/dividend situation is often "messy" with waiting for the posting of new shares, selling out the right amount etc. Also, there is the question of the margining of a stock purchase rather than continuing to play the options with much less. Another advantage to trading out rather than an exercise is that you can try to time your moves. Sell the options on an upmove and wait for the next pull back to buy some stock or to roll into later month options. You'll have more flexibility. Of course, you won't have ownership over the weekend unless you exercise. If the stock gets taken over Friday night, you won't profit if you sold the option outright. As you see, there are many concerns to consider.

Now for the dry part. The new stock comes from treasury supply. As for why a company will issue a stock dividend versus a stock split, it is largely a matter of corporate book keeping. For the individual trader, we can think of dividends and splits in the same way. Whether, in an accounting sense, one is dilutive towards earnings, I'll pass that along to the bean counters.

As for your statement that you bought the option before the record date, that doesn't matter. As I've explained with the term adjustments, a option buyer can assume the rights at any time with a simple purchase. As a matter of fact, if you sell out on Friday, the buyer who takes it from you will exercise it under the same terms available to you when you were the owner.


Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

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