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How Options React to a Stock Split

Montréal Exchange
July 22, 2021
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How Options React to a Stock Split

Companies decide to split their stock when the price has run up and the stock has become too expensive for retail investors. Once a stock splits, nothing fundamental has changed, and the shares should not be worth any more or less than before. The same logic holds true for the underlying option contracts.

What Is a Stock Split?

A company’s board of directors is responsible for authorizing a stock split, and typically do so after a few years of the shares appreciating in value. Retail investors might hesitate to buy 50 shares of a stock trading at $500 but would like the opportunity to buy 100 shares of the same company at $250.

In essence, the company is valued at the exact same amount after the split as before. The 50 shares at a price of $500 have the same value as 100 shares at $250.

What Happens to the Options?

Much like the equity component, the value of an option contract will not change in reaction to a stock split.

The Canadian Derivatives Clearing Corporation (or the Options Clearing Corporation for U.S. stocks) will automatically handle the split, so no action is required from the option holder. The process is known as “being made whole.” It implies that the option holder is not positively or negatively affected in any way, and receives a new set of assets of equal value.

As an example, if you own one contract (regardless if it is a call or put) with a $60 strike price and the stock underwent a two-for-one split, you now own two contracts with a $30 strike price.

An option chain that is in the money before the stock split will remain in the money, while an out-of-the-money option will similarly remain out of the money after the split.

What About Reverse Splits?

Reverse splits work in the opposite direction. They consist of a company consolidating the number of shares into fewer but more valuable shares. For example, a four-to-one reverse split means that each share will be converted to 0.25 shares that are four times more valuable. 

If an investor owns 400 shares of XYZ that are trading at $2 and the board authorizes a reverse one-for-four split, the investor will own 100 shares of the same stock, but they will trade at $8. Again, the total value of the shares will not change.

The impact of a reverse stock split in the options market is no different. In the above example, if an investor owns four call options with a $3 strike price, he or she will receive one new call option with a $12 strike price.

Conclusion: Nothing Complicated

The impact of a stock split on the options market is quite straightforward: investors will not be affected in any way. However, there might be some additional costs when a stock splits: it leaves investors with twice as many options, so the final commission fee will double.

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Bourse de Montreal Inc.’s prior written consent.  This information is provided for information purposes only. Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this publication, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information.  This publication is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice.  The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange,TSX Venture Exchange and/or Montreal Exchange.  TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  TMX, the TMX design, The Future is Yours to See., Toronto Stock Exchange, TSX, TSX Venture Exchange, TSXV, and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc.  Montreal Exchange, MX are the trademarks of Bourse de Montréal Inc. and are used under license. All other trademarks used herein are the property of their respective owners.

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