Adjusted free option: Meaning, Criticisms & Real-World Uses

What Is an Adjusted Option?

An adjusted option refers to a derivative contract whose original terms, primarily the strike price and the number of underlying asset shares it represents, have been modified in response to corporate actions taken by the issuer of the underlying security. This concept is central to financial derivatives, ensuring that option holders are neither unfairly advantaged nor disadvantaged by events like stock splits, mergers, or significant dividends. An adjusted option aims to preserve the total value of the contract before and after the corporate event.

It is important to note that the specific term "Adjusted Free Option" is not a standard or recognized financial term in practice. The phrase appears to combine "Adjusted Option" (as discussed here) with the concept of a "free option," which typically arises in real options analysis where an investment opportunity exists without an upfront cost for the right to pursue it. This article focuses on the "Adjusted Option" as it pertains to exchange-traded derivative contracts.

History and Origin

The need for adjusting option contracts arose with the increasing popularity and standardization of options trading. As financial markets evolved and companies frequently engaged in corporate actions, a mechanism was required to ensure fairness and continuity for option holders. Early forms of option contracts existed for centuries, but modern, standardized exchange-traded options began in the United States with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. The advent of liquid, centralized markets for these financial instruments necessitated clear rules for handling corporate events.

The Options Clearing Corporation (OCC), established in 1973, plays a crucial role as the central clearinghouse for all listed options in the U.S. and is responsible for determining and implementing these adjustments. The OCC's Bylaws and Rules authorize it to make adjustments to listed options when certain events occur, such as stock dividends, stock distributions, stock splits, reverse stock splits, rights offerings, distributions, reorganizations, recapitalizations, reclassifications, or mergers, consolidations, dissolutions, or liquidations of the underlying security's issuer.¹⁰ The OCC publishes information memos detailing the terms of these adjustments, ensuring transparency for market participants.⁸, ⁹

Key Takeaways

An adjusted option is a derivative contract whose terms are modified to account for corporate actions affecting its underlying security.
The primary goal of an adjustment is to preserve the intrinsic value and overall market value of the option contract for the holder.
The Options Clearing Corporation (OCC) determines and implements these adjustments to ensure market fairness and continuity.
Adjusted options typically arise from events like stock splits, reverse splits, special dividends, mergers, and acquisitions.
While an option may become adjusted, new, unadjusted option series are typically issued reflecting the post-corporate action terms.

Interpreting the Adjusted Option

Interpreting an adjusted option primarily involves understanding how the terms of the original contract have been altered to reflect a corporate event. The most common adjustments relate to the strike price and the number of shares an option contract controls. The aim is to ensure the holder's economic position remains equivalent before and after the adjustment.

For instance, in a standard forward stock split, if a company announces a 2-for-1 split, the original strike price of an option contract would be divided by two, and the number of shares represented by that single contract would double. This keeps the total notional value of the contract constant. The adjustment ensures that neither the buyer nor the seller of the option experiences an unintended gain or loss solely due to the corporate action. Similarly, a reverse stock split will lead to an increase in the strike price and a reduction in the number of shares per contract.⁷

An adjusted option may sometimes be less liquid than a standard option due to their non-standard terms. Traders and investors should always refer to the official information memos published by The Options Clearing Corporation (OCC) for precise details on any adjustments to their specific option contracts.

Hypothetical Example

Consider an investor who holds one call option contract on Company ABC, with a strike price of $100 and an expiration in three months. This contract typically represents 100 shares of the underlying asset.

Suppose Company ABC announces a 2-for-1 stock split. This means that for every one share of ABC stock owned, shareholders will now receive two shares, and the stock price will approximately halve. To maintain the equivalent economic value of the option contract, the OCC will adjust the terms as follows:

Strike Price Adjustment: The original strike price of $100 is divided by the split ratio (2), resulting in a new strike price of $50.
Shares Per Contract Adjustment: The number of shares controlled by the single option contract doubles from 100 to 200.

So, the investor's single original adjusted option now gives them the right to buy 200 shares of Company ABC at a strike price of $50 per share. Before the split, the total cost to exercise was (100 \text{ shares} \times $100/\text{share} = $10,000). After the adjustment, the total cost to exercise remains the same: (200 \text{ shares} \times $50/\text{share} = $10,000). This "making whole" adjustment prevents the investor from gaining or losing value solely because of the corporate action.

Practical Applications

Adjusted options are a crucial aspect of the options trading landscape, primarily serving to maintain the economic integrity of option contracts following various corporate actions. Their practical applications include:

Preserving Investor Equity: The most significant application is ensuring that option holders' positions are "made whole" after events like stock splits, reverse splits, mergers, or special dividends. Without these adjustments, investors could experience significant unintended gains or losses, undermining the fairness of the derivatives market.
Facilitating Market Continuity: Adjustments allow existing option contracts to continue trading, albeit with modified terms, preventing abrupt disruptions in the market. This supports continuous trading activity on affected underlying assets.
Regulatory Compliance: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), oversee the fairness and transparency of financial markets. The uniform rules and processes implemented by The Options Clearing Corporation (OCC) for adjusting options align with these regulatory objectives, providing clear guidelines for market participants and mitigating potential disputes arising from corporate events.⁶ For example, a recent reverse stock split announced by Velo3D, Inc. in July 2025, included a statement about "Proportional adjustments also will be made to the exercise prices of Velo3D's outstanding stock options and warrants."⁵
Risk Management: For market makers and institutions, understanding and anticipating option adjustments is vital for effective risk management. It allows them to appropriately price and hedge positions that might be affected by impending corporate actions.

Limitations and Criticisms

While adjusted options serve to maintain fairness in the derivatives market, they come with certain limitations and criticisms.

One significant drawback is the potential impact on liquidity. Adjusted options, sometimes referred to as "non-standard options," often experience lower trading volume and open interest compared to standard option contracts.⁴ This reduced liquidity can make it challenging for investors to enter or exit positions at desirable prices, as bid-ask spreads may widen. Market makers might be the primary counterparty for such contracts, and the absence of competition from other retail traders can impact pricing.³

Furthermore, the complexity of understanding these adjustments can be a barrier for some traders. While the Options Clearing Corporation (OCC) provides detailed information memos for each corporate actions, the specifics can vary, requiring diligent research from investors. The existence of multiple options series for the same underlying security (some adjusted, some new and unadjusted) can also lead to confusion in option chains.

Another criticism, particularly relevant when discussing the broader "free option" concept in real options analysis, is the potential for managerial discretion to justify otherwise unprofitable projects. Some academics suggest that while real options can add significant value by providing flexibility, misapplication of the theory can lead to overvaluation or the pursuit of poor investment decisions.² However, this criticism applies more to the strategic business application of "real options" rather than the operational adjustments of exchange-traded options.

Adjusted Option vs. Standard Option

The key difference between an adjusted option and a standard option lies in the modification of their contract terms. A standard option contract has fixed, predetermined terms: a specific strike price, expiration date, and typically represents 100 shares of the underlying asset. These terms remain unchanged throughout the life of the option unless a corporate action occurs.

An adjusted option, conversely, is a standard option that has undergone a change in its original terms. This modification, usually enacted by The Options Clearing Corporation (OCC), alters the strike price and/or the number of shares represented by the contract to account for events like stock splits, special dividends, mergers, or acquisitions. The purpose of these adjustments is to "make whole" the option holder, ensuring that the total economic value of their position remains consistent before and after the corporate event. While standard options are generally highly liquid, adjusted options may experience reduced liquidity due to their non-standard specifications.

FAQs

Q1: What kind of corporate actions lead to an adjusted option?

An option contract can become adjusted due to various corporate actions impacting the underlying asset. Common events include stock splits (both forward and reverse), special cash dividends, stock distributions, mergers, and acquisitions.

Q2: Who is responsible for adjusting option contracts?

In the United States, The Options Clearing Corporation (OCC) is the entity responsible for determining and implementing adjustments to listed option contracts following corporate actions. They publish information memos detailing the specific changes.¹

Q3: How can I tell if an option I own has been adjusted?

Your brokerage platform will typically display an "A" or a similar indicator next to the option symbol to signify an adjustment. Additionally, the strike price might not align with the typical increments of other options in the same series, and the number of shares per contract might be something other than 100. Always check the official OCC information memos for definitive details.

Q4: Does an adjusted option affect the value of my option contract?

The intention of an adjusted option is to ensure that the total intrinsic value of your contract remains unchanged immediately after the corporate action. While the strike price and shares per contract are modified, the overall economic position of the option holder is preserved, preventing artificial gains or losses from the corporate event itself. The option premium will reflect these new terms.

Q5: Can I still trade an adjusted option?

Yes, adjusted options can typically still be traded. However, they may experience reduced liquidity compared to new, standard option series issued after the corporate action. This can sometimes lead to wider bid-ask spreads, making it potentially harder to execute trades efficiently.