Publicly traded companies may decide to split its stock for various reasons. If a company's stock price has gone up, the price may be too high for investors to purchase shares, and a stock split lowers the price of shares making them more attractive. A stock split means that existing shareholders receive additional shares, but the value of the shares will not increase due to the stock split. When a stock split is announced, an options contract undergoes an adjustment called "being made whole."
What Is a Stock Split?
"Being made whole" means the options contract is modified so that the holder is neither negatively nor positively affected by the corporate action. While a stock split adjusts the price of an option's underlying security, the contract is adjusted so that any changes in price due to the split do not affect the value of the option. If your option is purchased post-split (that is, after the split is announced), it will not be adjusted because it already reflects the post-split price of the underlying security. The Options Clearing Corporation will automatically make these adjustments for the sake of orderly and smooth functioning markets.
A stock split will not increase the value of each share, but each stockholder will receive additional shares.
Stock Split Calculations
If a company with 20 million shares announces a 2-for-1 stock split, shareholders receive one additional share of stock for each share they already own. The company's total number of shares outstanding is now 40 million. Because of the split, the value of each share is halved. A share that was worth $16 before the split will now be worth $8.
The "being made whole" calculation is relatively straightforward for options. Each option contract typically controls 100 shares of an underlying security at a predetermined strike price. The new share ownership is generated by taking the split ratio and multiplying by 100 while the new strike price is generated by taking the old strike price and dividing by the split ratio.
For example, if you buy a call option that controls 100 shares of XYZ with a strike price of $75. If XYZ announces a 2:1 stock split, the contract would now control 200 shares with a strike price of $37.50. On the other hand, if the stock split is 3 for 2, the option would control 150 shares with a strike price of $50.
- A stock split announcement means that an options contract undergoes an adjustment called "being made whole."
- A stock split means that existing shareholders will receive additional shares, but the value of the shares will not increase at the time of the split.
- Similarly, a stock split will increase the total number of shares outstanding but will not increase the market capitalization of a company.
A reverse split also reverses the adjustment process. For example, if you buy a call option that controls 100 shares of XYZ with a strike price of $5. If XYZ announces a 1:5 stock split, the contract would now control 20 shares with a strike price of $25.
In February 2018, the insurance giant Aflac announced that it would do a 2-for-1 split effective March 16, 2018. The company stated "improving liquidity" as the reason for the split.
Stock Splits and Market Capitalization
While a stock split increases the total number of shares outstanding, it will not increase the market capitalization of a company—the total market value of its shares. Thus, a company with 20 million shares outstanding at $20 per share has a market capitalization of $400 million. A 2-for-1 stock split means that both the stock and its price are halved, and the total market value of the company's stock remains the same (40 million shares at $10 per share is $400 million).