What Is Adjusted Basic Option?
An adjusted basic option refers to an option contract whose original terms have been modified from their standardized form. This typically occurs in response to certain corporate actions undertaken by the issuer of the underlying asset. Such adjustments ensure that the economic value of the option is preserved for both the holder and the writer, preventing an unintended windfall or loss due to the corporate event30. Adjusted basic options are a crucial element within the broader field of financial derivatives and fall under the umbrella of corporate finance.
The modifications to an adjusted basic option can include changes to the strike price, the number of shares represented by each contract, or even the underlying deliverable itself29. These adjustments aim to neutralize the impact of events like stock splits, reverse stock splits, special dividends, mergers, acquisitions, or spin-offs27, 28. Without these adjustments, the value of outstanding option positions could be unfairly altered, disrupting market integrity.
History and Origin
The concept of options trading has roots stretching back to ancient Greece, but the formalization and standardization of option contracts are relatively modern developments26. Before 1973, options were primarily traded over-the-counter (OTC) with bespoke terms that made them difficult to price and manage25. A pivotal moment arrived with the establishment of the Chicago Board Options Exchange (CBOE) in April 1973, which introduced standardized options trading. This standardization brought transparency and liquidity to the market, but also necessitated clear rules for handling corporate actions that could alter the value of the underlying securities.
The need for adjusted basic options arose concurrently with the growth of the standardized options market. As a central clearinghouse, the Options Clearing Corporation (OCC) was established alongside the CBOE to guarantee option contracts and, critically, to manage the complex process of contract adjustments following corporate events24. The OCC, under the oversight of regulatory bodies like the Securities and Exchange Commission (SEC), developed and implemented policies to adjust options terms to maintain fairness and ensure that the economic value of the contracts remains consistent before and after a corporate action. For instance, the OCC's interpretative guidance on cash dividend adjustments demonstrates the meticulous approach to preserving contract value23.
Key Takeaways
- An adjusted basic option results from modifications to an existing option contract's terms.
- These adjustments are triggered by corporate actions such as stock splits, mergers, special dividends, and spin-offs.
- The primary goal of adjusting an option is to preserve its economic value and prevent windfalls or losses for option holders and writers.
- The Options Clearing Corporation (OCC) is responsible for determining and implementing the terms of these adjustments in the U.S. market.
- Adjusted options can sometimes appear with modified symbols, strike prices, or deliverables, and may have reduced liquidity.
Formula and Calculation
An adjusted basic option does not have a unique pricing formula distinct from standard options. Rather, the inputs into an option pricing model, such as the widely used Black-Scholes model, are modified to reflect the corporate action. The Black-Scholes model calculates the theoretical value of a European option based on several variables, including the underlying stock price, strike price, time to expiration, volatility, and risk-free interest rate22.
When a corporate action occurs, the relevant terms of the option contract are adjusted. For example, in a stock split, the strike price might be divided, and the number of shares per contract multiplied, to maintain the same aggregate value. The adjusted strike price and deliverable quantity would then be used in option pricing formulas. For instance, if a stock undergoes a 2-for-1 split, a call option with a strike price of $100 for 100 shares would be adjusted to two options, each with a strike price of $50 for 100 shares, or one option with a strike price of $50 for 200 shares, depending on the specific adjustment method. These adjustments ensure that the initial economic position of the option holder is preserved, allowing the risk management principles embedded in models like Black-Scholes to still apply.
Interpreting the Adjusted Basic Option
Interpreting an adjusted basic option requires careful attention to the specific changes made to its terms. Unlike standard options that always represent 100 shares of the underlying asset, an adjusted basic option may represent a different number of shares, a cash component, or even shares of a newly formed entity21. Traders must consult official announcements from the Options Clearing Corporation (OCC) to understand the exact nature of the adjustment. These "Information Memos" detail the revised contract specifications, including any changes to the expiration date, strike price, contract multiplier, or underlying deliverable19, 20.
An option that appears "in the money" based solely on its original strike price might not be so after an adjustment, due to changes in the deliverable or the number of contracts held18. It is critical to recognize that while the aggregate value of the position generally remains unchanged, the per-contract terms are altered. This often results in adjusted options having lower trading volume and open interest compared to their non-adjusted counterparts, impacting their liquidity16, 17.
Hypothetical Example
Consider XYZ Corp. stock, trading at $50 per share. An investor holds one call option on XYZ with a $55 strike price, set to expire in three months. Each option contract typically represents 100 shares.
Suppose XYZ Corp. announces a 2-for-1 stock split. This means for every one share owned, shareholders will now have two shares, and the share price will theoretically halve. After the split, XYZ stock trades at $25 per share.
To maintain the economic value of the outstanding call option, the Options Clearing Corporation (OCC) will adjust the contract. Instead of the original one contract for 100 shares at a $55 strike, the investor might now hold two call option contracts, each representing 100 shares, but with an adjusted strike price of $27.50.
Alternatively, the OCC could adjust the original contract to represent 200 shares at the original $55 strike price, though this is less common for simple splits. The key is that the total value required to exercise the option remains proportional to the pre-split value. Before the split, exercising would cost $55 x 100 = $5,500. After the split, exercising two contracts would cost $27.50 x 200 = $5,500. This example illustrates how an adjusted basic option ensures continuity for investors despite corporate actions.
Practical Applications
Adjusted basic options are a direct consequence of corporate actions and play a vital role in maintaining the fairness and integrity of the options market. They appear frequently in scenarios where a company's capital structure or share count changes. For instance, when a company issues a special cash dividend that is deemed "non-ordinary" by the Options Clearing Corporation (OCC), the strike price of the options may be reduced by the amount of the dividend to prevent a value erosion for the call option holder14, 15. Similarly, in the event of a spin-off, where a parent company creates a new, independent company from a portion of its business, the original option contracts may be adjusted to include shares of both the parent company and the spun-off entity as part of the deliverable13.
These adjustments are crucial for professional market makers and institutional investors who manage large portfolios of options. Without standardized adjustment procedures, corporate actions would create significant arbitrage opportunities or unintended losses, undermining confidence in the market. The Cboe Global Markets, for example, publishes detailed policies on how single stock options are adjusted for various corporate actions, ensuring transparency and predictability for market participants12.
Limitations and Criticisms
While designed to preserve economic value, adjusted basic options can introduce complexities for traders, particularly individual investors. One significant limitation is the potential for reduced liquidity. Since adjusted options are non-standard, they often have fewer buyers and sellers compared to newly issued, standard option series. This can lead to wider bid-ask spreads, making it more difficult and costly to enter or exit positions10, 11.
Furthermore, understanding the precise impact of an adjustment can be challenging. The adjusted strike price might be a fractional amount, and the deliverable might involve a combination of cash and shares, or shares of multiple entities, which deviates from the simple 100-share per contract norm9. This non-standardization can sometimes confuse investors and may lead to mispricing in the market due to a lack of clear understanding or insufficient trading activity8. Academic research and market observations sometimes highlight discrepancies between theoretical option prices (e.g., from the Black-Scholes model) and actual market prices, which can be exacerbated in less liquid, adjusted option series where assumptions of perfect market efficiency are harder to uphold7.
Adjusted Basic Option vs. Standardized Option
The key difference between an adjusted basic option and a standardized option lies in their terms and underlying deliverable. A standardized option adheres to uniform terms across exchanges, typically representing 100 shares of the underlying common stock at a round-number strike price. These options are characterized by high liquidity and straightforward interpretation, making them the default for most options trading.
In contrast, an adjusted basic option is a standardized option that has undergone modifications due to a corporate action. While its original intent was standardized, the adjustment renders its terms "non-standard." This can mean a change in the number of shares deliverable per contract (e.g., 50 shares or 150 shares), a fractional strike price (e.g., $43.33), or a deliverable that includes a combination of cash, shares, or shares from multiple companies5, 6. The primary source of confusion arises when traders expect the typical 100-share deliverable or round strike prices, and must instead navigate the unique terms of the adjusted contract.
FAQs
Q: Why do option contracts get adjusted?
A: Option contracts get adjusted to preserve their economic value when the underlying security undergoes a significant corporate action, such as a stock split, reverse stock split, special dividend, merger, or spin-off. This ensures neither the buyer nor the seller gains or loses unfairly due to the corporate event.
Q: Who determines the adjustments for option contracts?
A: In the United States, the Options Clearing Corporation (OCC) is responsible for determining and implementing the adjustments to outstanding option contracts. The OCC issues "Information Memos" detailing these changes for public access.
Q: How can I tell if an option I own has been adjusted?
A: Adjusted options often have an "A" or a numerical suffix next to their ticker symbol in your brokerage account or in option chains. Additionally, you might notice unusual strike prices (e.g., fractional values) or unusual volumes and open interest compared to other options in the same series3, 4. Always consult the OCC's Information Memos for official details.
Q: Are regular cash dividends cause for option adjustments?
A: No, ordinary, regular cash dividends generally do not lead to adjustments in option contracts. Option prices typically already factor in the expectation of these routine payments. Adjustments are usually made only for "special" or "extraordinary" cash dividends1, 2.
Q: How do adjustments impact the calculation of capital gain or loss?
A: Adjustments affect the cost basis of the option contract. When an option's terms are adjusted, the new strike price and deliverable amount will be used to determine the financial outcome upon exercise or sale. It is important to track these adjusted terms accurately for tax purposes and gain/loss calculations.