What Is an Adjusted Option?
An adjusted option is an option contract whose terms have been modified from their original, standardized specifications due to a significant corporate action affecting the underlying security. These modifications are made to ensure that the economic value and rights of the option holders and writers are preserved following events such as stock splits, mergers, special dividends, or spin-offs54, 55, 56, 57. Adjusted options fall under the broader category of derivatives, specifically within options trading.
The core purpose of adjusting an option is to maintain a fair balance for all parties involved, reflecting the changes in the underlying asset without altering the intrinsic value of the contract. For instance, if a stock undergoes a 2-for-1 split, an adjusted option might then represent double the number of shares at half the original strike price, or it might lead to a change in the quantity of shares deliverable per contract52, 53.
History and Origin
The concept of adjusted options emerged with the growth and standardization of the options market. As options became more widely traded following the establishment of formal exchanges like the Chicago Board Options Exchange (CBOE) in the early 1970s, the need for clear rules regarding the impact of corporate actions became paramount. The Options Clearing Corporation (OCC), founded in 1973, plays a central role in ensuring the integrity and stability of the U.S. options markets by acting as the guarantor and central clearinghouse for options transactions50, 51.
The OCC is responsible for determining and implementing adjustments to option contracts when corporate events occur47, 48, 49. These adjustments are formalized through "information memos" issued by the OCC, providing market participants with detailed terms of how each specific contract will be affected46. This standardization of adjustments helps maintain investor confidence and ensures that the economic intent of the original option contract is upheld despite changes to the underlying asset. A notable example illustrating such adjustments occurred during the 2015 spin-off of PayPal from eBay, where options on eBay were adjusted to account for the distribution of PayPal shares.
Key Takeaways
- An adjusted option's terms are modified due to corporate actions like stock splits, mergers, special dividends, or spin-offs.
- The primary goal of an adjustment is to preserve the economic value for both option holders and writers.
- The Options Clearing Corporation (OCC) is the entity primarily responsible for determining and implementing these adjustments in the U.S.
- Adjusted options can involve changes to the strike price, the number of shares represented by the contract, or even the type of deliverable.
- These options may exhibit lower liquidity compared to their standard counterparts due to their non-standard nature.
Interpreting the Adjusted Option
Interpreting an adjusted option requires careful attention to the specific terms of the adjustment, which are disseminated by the Options Clearing Corporation (OCC) through information memos44, 45. Unlike standard call options or put options where each contract typically represents 100 shares of the underlying stock, an adjusted option might represent a different number of shares, a combination of shares and cash, or even shares of a different company43.
Traders must understand that an adjusted option that appears "in the money" based on its stated strike price might not be, once the new deliverable or adjusted share quantity is considered42. For instance, if a company undergoes a reverse stock split, an option contract might now represent fewer shares at a proportionately lower strike price to maintain parity40, 41. Checking the OCC's information memos or the option chain on a brokerage platform for any "ADJ" or numeric suffix (e.g., "XYZ1") indicating an adjustment is crucial before making trading decisions36, 37, 38, 39.
Hypothetical Example
Consider an investor who owns a call option on Company ABC with a strike price of $50, expiring in three months. The option contract typically represents 100 shares.
Suppose Company ABC announces a 3-for-2 stock split. This means for every two shares of ABC stock owned, shareholders will receive three shares.
Following this corporate action, the Options Clearing Corporation (OCC) would adjust the terms of the outstanding option contracts. Instead of a new strike price, the adjustment might primarily impact the number of shares deliverable per contract and the option's symbol.
Before Adjustment:
- 1 ABC Call Option (Strike: $50) = Right to buy 100 shares of ABC at $50 per share.
After 3-for-2 Stock Split and Adjustment:
- The option contract will likely be adjusted so that it now represents 150 shares (100 * 3/2) of ABC. The strike price may also be adjusted. If the strike price were adjusted, it would be proportionally lower. However, some adjustments primarily change the deliverable, while keeping the original strike. For this example, let's assume the deliverable changes to 150 shares and the strike is adjusted to ( $33.33 ) (calculated as ( $50 \times (2/3) )).
- 1 ABC Adjusted Call Option = Right to buy 150 shares of ABC at an adjusted strike price of ( $33.33 ) per share.
The total value to be exchanged upon exercise remains economically equivalent to the original contract ($50 x 100 shares = $5,000 equivalent original value, vs. $33.33 x 150 shares = ~$5,000 equivalent adjusted value, allowing for rounding). This hypothetical scenario demonstrates how an adjusted option preserves the overall contractual value despite changes in the underlying share structure.
Practical Applications
Adjusted options primarily arise in the context of portfolio management and risk management when corporate events alter the nature of an underlying security. For investors holding existing option contracts, understanding adjusted options is critical to accurately assess the new terms of their positions and manage their derivatives market exposure35.
One key application is in maintaining existing positions. When a company undergoes a corporate action like a merger or a large special dividend, existing options are adjusted to reflect these changes. This ensures that the option holder's rights are not diluted, and the writer's obligations remain consistent with the altered underlying security34. For example, if a cash special dividend is paid, the strike price of a call option might be adjusted downwards to compensate33.
Another application lies in corporate hedging strategies. Companies using options to hedge against price movements in their own stock or other assets must be aware of how corporate actions can affect their hedges. Adjusted options ensure that their hedging instruments continue to align with their altered risk exposures. Information regarding specific option adjustments is publicly available through the Options Clearing Corporation's (OCC) information memos, which are critical resources for traders and institutions32.
Limitations and Criticisms
While designed to maintain fairness, adjusted options present several limitations and criticisms for market participants. The primary drawback is a significant reduction in liquidity for the adjusted contracts28, 29, 30, 31. When a standard option contract undergoes adjustment, new, standard option chains are typically introduced for the underlying security reflecting its new structure. Traders often gravitate towards these new standard contracts due to their higher volume and open interest, leaving the adjusted options with less trading activity26, 27. This reduced liquidity can make it challenging for investors to close their positions at desirable prices, potentially leading to increased slippage25.
Furthermore, the complexity of adjusted options can be a source of confusion for individual investors. The non-standard contract sizes, odd strike prices, and changes in deliverables require a detailed understanding of the specific adjustment terms23, 24. Misinterpretation of these terms can lead to unexpected outcomes upon exercise or assignment. The Securities and Exchange Commission (SEC) has issued warnings regarding the complexities and potential risks associated with complex or non-standard options, advising investors to thoroughly understand such products before trading22.
Another criticism is the potential for increased transaction costs if traders opt to close out an adjusted position and re-establish a position in a new, standard option chain to regain liquidity21. While essential for preserving economic value, the practical implications of trading and managing adjusted options necessitate careful attention and an understanding of the specific details of each adjustment.
Adjusted Option vs. Standard Option
The fundamental difference between an adjusted option and a standard option lies in their contract specifications. A standard option, often referred to as a "plain vanilla" option, is a uniform contract that typically represents 100 shares of the underlying security with a fixed strike price and expiration date20. These options are highly liquid and widely traded on exchanges.
In contrast, an adjusted option is a standard option whose terms have been modified by a clearing agency, such as the Options Clearing Corporation (OCC), in response to a corporate action affecting the underlying asset18, 19. These modifications can alter the number of shares represented by the contract (the multiplier), the strike price, or even the nature of the deliverable (e.g., a mix of cash and shares, or shares of a different company)16, 17. The primary goal of an adjusted option is to preserve the economic value of the original contract, ensuring that investors' rights and obligations remain consistent despite the corporate event15. However, this often results in lower liquidity for the adjusted contracts compared to newly issued standard options13, 14.
FAQs
What causes an option to become adjusted?
An option becomes adjusted due to corporate actions affecting the underlying asset. Common events include stock splits, reverse stock splits, mergers, acquisitions, special dividends, and spin-offs11, 12.
Who determines the terms of an adjusted option?
In the U.S. market, the Options Clearing Corporation (OCC) is responsible for determining and disseminating the terms of adjusted options. They issue information memos detailing the specific changes to contracts9, 10.
Can you trade an adjusted option?
Yes, you can trade an adjusted option. However, these contracts typically experience significantly lower liquidity compared to standard options, which can make it more challenging to enter or exit positions at desired prices7, 8.
Do adjusted options expire at different times than standard options?
No, adjustments to options contracts typically do not alter the expiration date. The changes primarily affect the strike price, the number of shares deliverable per contract, or the type of deliverable6.
How can I identify an adjusted option?
Brokerage platforms often indicate adjusted options with specific symbols, such as an "ADJ" tag, an "A" icon, or a numeric suffix added to the underlying stock symbol (e.g., XYZ1 instead of XYZ)3, 4, 5. Additionally, they may have unusual strike prices or low trading volume compared to other options in the same series1, 2.