A:

When the underlying stock of your option splits or even begins issuing a stock dividend, the contract undergoes an adjustment that is often referred to as "being made whole," which means the option contact is modified accordingly so that you are neither negatively nor positively affected by the corporate action. While a stock split will adjust the price of the underlying security of an option, the option is adjusted so that any changes in price due to the split do not affect the value of the option. Keep in mind that if your option is purchased post-split (i.e. after the split is announced) then your option will not be adjusted as it will have been created according to the new split price of the underlying security.

How do you calculate what the new option will be worth? Well, you typically don't need to worry about such things because the Options Clearing Corporation will automatically do it for you (for the sake of orderly and smooth markets). But if you are wondering how it's done, the calculation is relatively straightforward. Each option contract is typically in control of 100 shares of an underlying security at a predetermined strike price. To find the new coverage of the option, take the split ratio and multiply by the old coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio. Say, for example, you own a call for 100 shares of XYZ with a strike price of $75. Now, if XYZ had a stock split of 2 for 1, then the option would now be for 200 shares with a strike price of $37.50. If, on the other hand, the stock split was 3 for 2, then the option would be for 150 shares with a strike price of $50.

RELATED FAQS

  1. What risks should I consider taking a short put position?

    Learn what risks to consider before taking a short put position. Shorting puts is a great strategy to earn income in certain ...
  2. What happens if a software glitch fails to execute the strike price I set?

    Find out why trading software can be a double-edged sword, and learn what to do if your trade isn't executed because of a ...
  3. In what market situations might a short put be a profitable trade?

    Discover in what market situations a short put trade might be profitable. Selling puts is a good strategy when a trader is ...
  4. What is the relationship between implied volatility and the volatility skew?

    Learn what the relationship is between implied volatility and the volatility skew, and see how implied volatility impacts ...
RELATED TERMS
  1. Strike Width

    The difference between the strike price of an option and the ...
  2. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  3. Reference Equity

    The underlying equity that an investor is seeking price movement ...
  4. Boundary Conditions

    The maximum and minimum values used to indicate where the price ...
  5. Delta-Gamma Hedging

    An options hedging strategy that combines a delta hedge and a ...
  6. Gamma Hedging

    An options hedging strategy designed to reduce or eliminate the ...

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    4 Ways You Can Invest In Gold Without ...

  2. Active Trading Fundamentals

    How To Short Amazon Stock

  3. Forex Education

    Trading Forex Options: Process And Strategy

  4. Investing Basics

    Try Southwest Airlines Options To Avoid ...

  5. Options & Futures

    Tax Treatment For Call & Put Options

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!