What Is Adjusted Cash Option?
An Adjusted Cash Option refers to an options contract whose terms have been modified by a clearing organization, typically the Options Clearing Corporation (OCC), in response to a corporate action affecting the underlying security. These adjustments are made to preserve the economic value of the options contract for holders and writers when events like stock splits, mergers, special dividends, or spin-offs occur. The concept falls under the broader category of derivatives and options trading.
When a corporate action takes place, the original terms of an options contract, such as the strike price, the number of underlying shares represented by the contract, or even the option symbol, may be altered. The goal of an Adjusted Cash Option is to ensure that the aggregate value of the option position remains as consistent as possible before and after the corporate event. The OCC determines the terms of these adjustments, which can vary depending on the specific corporate action.31, 32, 33
History and Origin
The need for adjusting options contracts arose with the increasing complexity of financial markets and the frequent occurrence of corporate actions that directly impact the underlying securities of derivative instruments. Options, being financial derivatives that derive their value from an underlying asset, are directly affected by changes to that asset.28, 29, 30
The Options Clearing Corporation (OCC), as the central clearinghouse for options in the U.S., plays a pivotal role in standardizing and managing these adjustments. The OCC's by-laws and rules provide guidelines for how options contracts are to be adjusted in the event of various corporate actions. Historically, the OCC's Securities Committee was involved in determining adjustments, but over time, the authority shifted, with the OCC now having the sole discretion in applying its by-laws and interpretations to determine particular adjustments on a case-by-case basis. This process ensures that market participants are protected from unexpected changes in the value of their option positions due to corporate events.27
Key Takeaways
- An Adjusted Cash Option is an options contract whose terms have been modified due to a corporate action affecting its underlying security.
- These adjustments are made by the Options Clearing Corporation (OCC) to maintain the economic value of the option.
- Corporate actions triggering adjustments include stock splits, mergers, special dividends, and spin-offs.
- Adjustments can affect the strike price, the number of shares per contract, or the option symbol.
- The primary goal is to ensure fairness and consistency for options holders and writers.
Formula and Calculation
While there isn't a single universal formula for an "Adjusted Cash Option" as the adjustments depend on the specific corporate action, the underlying principle is to preserve the total value of the option contract. The adjustments often involve changes to the strike price and/or the number of deliverable shares, or the creation of a "basket" that includes cash or other securities.
For example, in a stock split, the original number of shares per contract and the strike price are adjusted proportionally. If a 2-for-1 stock split occurs, an option holder might end up with twice the number of contracts at half the original strike price, or the original contract might be adjusted to represent a larger number of shares at a reduced strike price.25, 26
Consider a scenario where an option contract originally represented 100 shares.
If a corporate action results in a change to the deliverable, the new deliverable might be a combination of shares and cash. The adjustment aims to ensure the intrinsic value remains consistent.
For a special cash dividend, the OCC may adjust the strike price downward by the amount of the dividend. This ensures that the option's intrinsic value is preserved, as the underlying stock's price is expected to drop by the dividend amount on the ex-dividend date.23, 24
Interpreting the Adjusted Cash Option
Interpreting an Adjusted Cash Option requires careful attention to the specific terms of the adjustment. When a corporate action impacts an underlying equity security, the OCC issues an information memo detailing the changes to the associated options contracts. These memos clarify how the strike price, deliverable, and contract multiplier have been altered.21, 22
For instance, if an option contract's symbol includes a numerical suffix (e.g., "XYZ1" instead of "XYZ"), it often indicates that the contract has been adjusted and no longer represents the standard 100-share deliverable. However, not all adjustments result in a new symbol; a change solely to the strike price due to a special cash dividend, for example, may not. Understanding these adjustments is crucial for traders to properly value their positions and manage potential assignment risk.19, 20
Hypothetical Example
Imagine an investor holds one call option contract for Company A, with a strike price of $50 and an expiration in three months. Each contract typically represents 100 shares of the underlying stock.
Now, suppose Company A announces a 2-for-1 stock split. This is a common corporate action where each existing share is split into two, effectively halving the share price. Without an adjustment, the option holder would have the right to buy 100 shares at $50, which would be disproportionate to the new, lower share price.
The OCC would then adjust the option contract. In this 2-for-1 split scenario, the adjustment typically means the investor now holds two option contracts. Each new contract would have a strike price of $25, and each would represent 100 shares. Alternatively, the original contract might remain, but its terms are adjusted so that it now represents 200 shares at a strike price of $25. In both cases, the total potential value and obligation remain economically equivalent to the pre-split position. The total cost to exercise the original contract was $5,000 (100 shares x $50), and after the adjustment, exercising two contracts would cost $5,000 (200 shares x $25), or the single adjusted contract would cost $5,000 (200 shares x $25). This ensures fairness for all parties involved in the options market.
Practical Applications
Adjusted Cash Options are a fundamental aspect of maintaining fairness and order in the derivatives market following significant corporate events. They are practically applied across various scenarios in investing and market analysis. For portfolio managers and individual investors who utilize options strategies, understanding these adjustments is paramount.
For example, when a company undergoes a merger or acquisition, the options on the target company's stock will be adjusted to reflect the terms of the merger, which might involve a cash component, shares of the acquiring company, or a combination. The OCC's role in determining these adjustments ensures that the financial obligations and rights embedded in the options contracts are preserved. This also extends to how risk management is conducted for portfolios that include options, as the adjustments can significantly alter the exposure. The importance of these adjustments in maintaining market integrity is highlighted in academic discussions about the impact of corporate actions on derivatives.17, 18
Limitations and Criticisms
While Adjusted Cash Options are designed to maintain economic equivalence, they can introduce complexities and, in some rare instances, lead to unexpected outcomes for market participants. One criticism relates to the discretion the Options Clearing Corporation (OCC) sometimes exercises in determining adjustments, particularly concerning "non-ordinary" dividends. While the OCC aims for consistency, its case-by-case evaluation can occasionally diverge from market expectations, as seen in past instances with dividend adjustments.16
Another limitation can arise from the practical implications for traders. An Adjusted Cash Option might lead to a "non-standard" contract, meaning it no longer represents a neat 100 shares of the underlying, or it might deliver a "basket" of securities and cash. These non-standard contracts can sometimes be less liquid or harder to price accurately, potentially affecting bid-ask spreads and overall market efficiency. Investors might also face challenges in managing their positions if they prefer to deal with standard 100-share contracts. Despite the OCC's efforts to minimize disruption and maintain the economic value of options, the subjective nature of some corporate actions and their impact on derivative contracts can still pose challenges.14, 15
Adjusted Cash Option vs. Cash-Settled Option
An Adjusted Cash Option is distinct from a Cash-Settled Option, though both involve cash in their settlement or adjustment. The key difference lies in why cash is involved and when it is determined.
A Cash-Settled Option, such as most index options, is designed from its inception to be settled in cash at expiration, rather than through the physical delivery of the underlying asset. The profit or loss is simply the difference between the option's intrinsic value and its premium, settled as a debit or credit to the trading account.12, 13
In contrast, an Adjusted Cash Option is an option that originally might have been physically settled (e.g., an equity option), but its terms, including potentially the deliverable, have been modified due to an intervening corporate action. The "cash" component in an Adjusted Cash Option arises from this corporate action and the OCC's subsequent adjustment to preserve the option's economic value. This adjustment might involve a cash payment as part of the new deliverable or a change in the strike price to reflect a cash distribution from the underlying company. The underlying confusion often stems from the involvement of "cash," but it's the reason for that involvement—an initial design for cash settlement versus an adjustment due to a corporate event—that differentiates the two.
##11 FAQs
What causes an option contract to become an Adjusted Cash Option?
An option contract becomes an Adjusted Cash Option primarily due to corporate actions affecting the underlying security. These actions can include stock splits, reverse stock splits, mergers, acquisitions, spin-offs, and special cash dividends or distributions. The Options Clearing Corporation (OCC) makes these adjustments to ensure that the economic value of the options contract is preserved for all parties.
##8, 9, 10# How does the Options Clearing Corporation (OCC) determine adjustments?
The OCC determines adjustments based on its by-laws, rules, and interpretations of how a corporate action impacts the underlying security. The goal is to maintain the intrinsic value of the options contract. The specific adjustment can vary, ranging from modifying the strike price and the number of shares per contract to changing the option symbol or even creating a "basket" deliverable that includes cash or other securities.
##6, 7# Can an Adjusted Cash Option still be physically settled?
It depends on the nature of the adjustment. While many equity options are typically physically settled, an adjustment due to a corporate action might alter the deliverable to include a cash component or even convert it entirely to a cash-settled instrument if the underlying security fundamentally changes (e.g., in a cash-out merger). The OCC's information memos detail the specific deliverable for adjusted contracts.
##4, 5# How can I identify an Adjusted Cash Option in my brokerage account?
Your brokerage statement or trading platform should indicate if an option contract has been adjusted. Often, adjusted contracts will have a modified option symbol, sometimes with a numerical suffix (e.g., XYZ1 instead of XYZ), to denote a non-standard deliverable. You can also refer to the Options Clearing Corporation (OCC) website for official information memos detailing all contract adjustments.
##3# Does a regular cash dividend lead to an Adjusted Cash Option?
Generally, no. Regular, ordinary cash dividends typically do not result in an adjustment to options contracts. The market usually accounts for these dividends in the option's price. Adjustments are usually made for "special" or "non-ordinary" dividends, which are larger or outside the company's regular dividend policy, as these can have a more significant and unpredictable impact on the underlying stock price.1, 2