Impacts of Dividends and Stock Splits on Stock Options Terms
We will cover following topics
Introduction
Dividends and stock splits are important events that can significantly influence the terms and characteristics of stock options. In this chapter, we will explore how dividends and stock splits impact options contracts and how investors need to be aware of these events when trading or holding options positions.
Dividends and Options Terms
Dividends are periodic payments made by a company to its shareholders as a distribution of profits. When a company pays dividends, it can have implications for stock options.
Options contracts give the holder the right, but not the obligation, to buy or sell the underlying stock at a predetermined price (strike price) by a certain expiration date. For call options, if the underlying stock goes ex-dividend (i.e., the dividend is declared and deducted from the stock price), the stock price tends to drop, which could impact the value of the call option. Conversely, put options might increase in value due to the anticipated drop in the stock price.
Example: Suppose an investor holds a call option with a strike price of USD 100 on a stock that is currently trading at USD 110. If the stock pays a dividend of USD 2, the stock price may drop to USD 108. This decrease in stock price could impact the value of the call option, potentially reducing its value.
Stock Splits and Options Adjustments
A stock split involves dividing existing shares of stock into multiple shares, typically to make them more affordable for retail investors. Stock splits can also affect options contracts.
Options contracts are typically based on a specific number of shares (usually 100 shares per contract). When a stock split occurs, the number of shares underlying an option contract changes, and adjustments are required to maintain the contract’s integrity.
For example, in a 2-for-1 stock split, each shareholder receives an additional share for every share owned. If an investor holds a call option with a strike price of USD 100 and the stock undergoes a 2-for-1 split, the terms of the option contract might be adjusted. The strike price could be halved to USD 50, and the number of shares represented by one contract could double to 200 shares.
Example: An investor holds a call option with a strike price of USD 100 and a stock split occurs, resulting in a new strike price of USD 50. If the option contract originally covered 100 shares, it might now cover 200 shares after the split.
Conclusion
Dividends and stock splits are crucial events that can impact the value and terms of options contracts. Understanding how these events can influence options allows investors to make informed decisions and manage their options positions effectively. Being aware of the potential adjustments that might occur due to stock splits ensures that investors are well-prepared for changes in contract terms.