What Is the Adjusted Exercise Price?
The adjusted exercise price is an option contract's strike price after adjustments have been made for corporate actions such as stock splits or special dividends made to its underlying security. Any time that changes occur to the securities on which options are written, the strike price and delivery quantity of the underlying security must be adjusted accordingly in order to ensure that neither the long or short holder of the options are negatively affected.
The adjusted strike price may also refer to the strike prices for options written on Ginnie Mae (GNMA) pass through certificates. The interest rates assigned to GNMA pass through certificates differ from that of their referenced benchmark rate. As such, these rates must be adjusted so that the investor will receive the same yield.
- An adjusted exercise price accommodates technical changes in an option contract's underlying contract such as a special dividend or stock split.
- The adjusted strike price allows for trading continuity for holders of an options contract before the corporate action takes place that changes the underlying's price or attributes.
- Normally, adjusted exercise prices will exist until an affected options series expires, while new strike prices are simultaneously added post-hoc.
How an Adjusted Exercise Price Works
Options contract terms must be adjusted if the underlying stock undergoes a reorganization that directly affects the original terms of its options. These may include stock splits, special dividends, and stock dividends. A two for one stock split, for instance, will result in twice the number of shares but at half the price. The holder of an option contract as a result of a two for one stock split will thus be granted twice as many option contracts but at half the original strike price.
Adjusted exercise prices may result in fractional strike prices, but will only affect options series that exist prior to the corporate action that caused the adjustment. New series and existing series will also have newly created strike prices added that are effectively un-adjusted after the fact.
Note that strike prices are not adjusted for the payment of ordinary dividends, ticker symbol changes, or due to a merger or acquisition.
Example of an Adjusted Exercise Price
If there is a different multiplier for the stock split, like a 3:1 stock split, then three times as many outstanding shares will exist at a third of their original market price. Therefore, options strike prices must be reduced by one third as well. Therefore you may see strike prices with decimals after them (e.g. the 40 strike will become the 13.333 strike). New strikes (such as the 10 and 15 strike) may then be added around the split strikes as time goes on.
A reverse stock split operates in the opposite direction, and results in the reduction of outstanding shares with an accompanying increase in the price of the underlying stock. The holder of an option contract will still have the same number of contracts but with an increase in strike price based on the reverse split value. The option contract, however, will now represent a reduced number of shares based on the reverse stock split value.
If a stock pays out an extraordinary (special) cash dividend, that is not paid out on a quarterly or another regular basis, then the strike may also be reduced by the dividend amount - but only if the cash dividend amount exceeds $12.50 per contract. If a company pays a stock dividend—that is, it pays shareholders in extra shares instead of in cash—then the strike price must also be reduced by the amount of the dividend's value.