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In addition to the better known risks involved with trading specific asset classes, options hold an additional unique risk that traders will periodically encounter: the adjusted option. An adjusted option is a contract that existed prior to certain corporate actions and has been changed to reflect the structural and value changes in the underlying security. Stock splits, large cash dividends, mergers, acquisitions and spin-offs are some of the corporate actions that prompt an adjustment to option contracts.

This article is a two-part series; Part 1 provides fundamental information on adjusted options with a focus on those resulting from stock splits. Part 2 will appear tomorrow and focuses on adjustments that result from Mergers & Acquisitions (M&As) and spin-offs. Calculations to determine intrinsic and extrinsic value for these options are provided in each case.

Stock Splits

The easiest, most straightforward example of an adjusted option due to a stock split is one that existed prior to a 2 for 1 (2:1) stock split. Typically, the new adjusted option is indistinguishable from options in place prior to the split. The following occurs on the day the stock reflects the 2:1 split:

In each case, the option contract controls 100 shares of stock (the option package) and has a multiplier of 100. These are actually two distinct concepts for an equity option, but often are tied together.

Although the new option is technically an adjusted option, it doesn’t highlight the type of adjusted options that can really wreak havoc for the trader. Let’s look at a less obvious split example. Consider a 3 for 2 split where we actually have a change in the option package and multiplier.

The original option contract controlled 100 shares of stock (the option package) and had a multiplier of 100, but the adjusted option contract controls 150 shares of stock with a multiplier of 150. The number of shares has increased by 3/2, while the value of the stock has decreased by this amount (is now 2/3s). Similarly, the number of shares in the option package has increased by 3/2’s while the option strike price has decreased by this amount (is now 2/3s).

A trader seeking to purchase the adjusted XYZ option package will pay the market value times the option multiplier. In this case, the cost of 1 XYZ Jan 60 call at $2 per contract is $300 [1 x 2 x 150].

It’s important to truly understand contract terminology to move forward with adjusted option pricing and value for more complex corporate actions. The definitions that follow should serve as a nice foundation.

Definitions:

Option Package/Deliverable: The option package is the underlying securities and/or cash that are delivered when the option is exercised or assigned. The most common option package for a standard equity option is 100 shares of stock.

Strike Price: The strike price is a component cost of the exercise or assignment value; Strike Price x Multiplier = Exercise Cost / Sale Value or Assignment Cost / Sale Value.

Multiplier: The multiplier is a designated contract value similar to strike price and the option package. Although the common multiplier value is 100, an adjusted option may have a different multiplier value. The multiplier is used to determine both deliverable values and total premiums.

Exercise/Assignment Value: The assignment or exercise value is calculated using the option multiplier and strike price; Multiplier x Strike Price = Exercise Value. The most common multiplier for a standard equity option is 100. An equity option with a multiplier of 100 and a strike price of 20 has an exercise or assignment value of 100 x 20 = $2,000. Although it’s convenient to think we are paying $20 per share for 100 shares of stock, such an approach makes valuing adjusted options more confusing. It’s simply not accurate.

Market Quote: The market quote for an option is the National Best Bid and Offer (NBBO) available when the options markets are open. The market quote, combined with the multiplier, is used to determine the total premium cost to buy or sell on option.

Premium Cost: The premium is the amount paid when buying, or the amount received when selling, an option. It is calculated using the multiplier and market quote; Market Quote x Multiplier = Premium Cost.

Two important considerations in which an individual needs to focus for adjusted options is the current correct market value for the underlying package, as well as the premium cost. Specifically, the trader needs to understand the true intrinsic and extrinsic value for adjusted options. This is most difficult when the underlying security presents something other than 100 shares of stocks and/or significant cash values. Mergers, acquisitions and spin-offs are the corporate actions related to such adjustments and will appear in Part 2.

In the past, broker systems were not equipped to stop such a transaction from occurring because they did not breakout the deliverable package. There was no alert to indicate insufficient shares were available for delivery even if the trade occurred in an IRA with a level 0 or 1 option approval [i.e., no naked options]. Hopefully this provides some insight to how a less than inquisitive trader may end up holding an adjusted option.

Current Example—Split (3:2)

Adjusted options can cause trouble for traders when the multiplier for the option is something different than 100—i.e. after a 3:2 stock split. One possible hint for the trader is a funky strike price; however, not all adjusted options that result from such a split will have an atypical strike [consider a 30 strike call that now becomes a 20 strike call].  Unfortunately, a second telltale sign is the amount of money debited from your account after trading this type of adjusted option—a less than pleasant “after the fact” surprise. Buying a 20 strike call with a 150 multiplier and an offer price of $4 will result in a $600 debit from the account.

The best way to identify an option with adjusted terms is by recognizing that the option root is different. Typically traders will first review an option chain when evaluating prospects—this is the perfect time to catch yourself before you unknowingly trade such a contract. Since not all quoting services provide clear detail regarding adjusted options, check the contract adjustments section of an option exchange web site or the Options Clearing Corporation (OCC) if the symbol seems different.

The following information was obtained from the Chicago Board of Options Exchange (CBOE) on June 27^th 2006:

Figure 1: Sample Contract Adjustments Page from the CBOE

Detail about the action that merited an adjustment, as well as the adjustment to the option contracts, can be found by clicking on the link provided. Here’s a bit more detail from Figure 1:

Figure 2: CBOE Contract Adjustments Detailed View

Delphi Financial Group (DFG) completed a 3:2 stock split on June 1^st which resulted in contract adjustments for options that existed as of 6-1-06, including July options. Reviewing an option quote chain using the CBOE delayed quotes, we note the following:

Figure 3: DFG Option chain using CBOE delayed quotes

The Optionetics.com website did not include these adjusted options for the DFG chain or other chains that were searched. It’s important, however, to always check duplicate strike prices. In Figure 3, there are two Jul 30 calls quoted, DFGGF and DJHGF. Even those traders that are not very familiar with DFG options would hazard a guess that the DFG root represents the standard options while the DJH root represents the adjusted options. Both should be reviewed to determine the difference between these two “seemingly the same” option contracts.

Quotes from your broker should provide the multiplier and contract detail when different. The following quotes from Fidelity are provided for review. [Important note: this is not an endorsement for any broker; identify how your broker highlights adjusted options]:

Figure 4a: Fidelity Quote for DFGGF                     Figure 4b: Fidelity Quote for DJHGF

Figure 4c: Detailed Contract Specifications for DJHGF from Fidelity.com

In this case, the option multiplier is 150 and the option package controls 150 shares of DFG. The asking price for the adjusted 30 strike call is 4.50, so a trader will be debited $675 (4.5 x 1.5 x 100) for each contract purchased. In the event the trader elects to exercise the rights of the call, the debit from the account will be $4,500 for 150 shares of DFG (30 x 150). This is something any trader must know in advance of any transaction. Again, consider a covered call position—the option trader must be aware that any call sold to open will cover 150 shares of stock, not 100.

Intrinsic & Extrinsic Values

The underlying package for DJHGF is 150 shares of DFG, which closed at $34.18 when the quotes were pulled. The market value at the offer price for the option was $4.50. Using this information, the intrinsic and extrinsic value calculations are pretty straightforward, but we’ll complete them in a slightly different manner in preparation for more complex packages.

Using a more basic approach, the intrinsic value can be calculated as follows: Stock Price – Strike Price = 34.18 – 30 = 4.18. We still need to use the multiplier to obtain: 4.18 x 150 = 627. This is the same value obtained in the table. Similarly, the extrinsic value can be calculated as follows: Option Premium – (Stock Price – Strike Price) = 4.50 – (34.18 – 30) = 0.32. Again, using the multiplier we obtain:  0.32 x 150 = $48.

Summary

The theme for June’s Analytical Toolbox is Risk and the existence of adjusted options represents some risk to options traders—even those that are very experienced. Although you may be familiar with a specific underlying and recent corporate actions related to it, keep in mind that some options have been in existence for a long time. Currently, Long Term Equity Anticipation Securities (LEAPS) are available through January 2009 for some securities. That’s a 2-1/2 year period for these contracts to be exposed to potential corporate actions. January options include plenty that have been adjusted.

You must fully understand the contract pricing, rights and obligation for the options you trade and recognize that if a market quote for an option seems to be too good to be true, it probably is. You can bet the traders on the floor know about corporate actions impacting the underlying securities they trade and how to price the adjustments. When something doesn’t seem quite right, check it out prior to establishing a position.

To see the other articles by this author, please click here.


Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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