The Adjusted Gross Option is a lesser-known term that refers to modifications made to the terms of an options contract, typically in response to a corporate action affecting the underlying security. These adjustments are a critical component of derivatives and ensure fairness for options traders when events like stock splits, mergers, or special dividends alter the value or structure of the shares. The broader financial category to which this term belongs is derivatives.
What Is Adjusted Gross Option?
An Adjusted Gross Option refers to an existing options contract whose terms—such as the number of underlying shares, the strike price, or occasionally the expiration date—have been modified by a clearing organization, most notably the Options Clearing Corporation (OCC). These adjustments occur to account for corporate actions that change the fundamental nature or value of the underlying asset, ensuring that the economic value of the option remains consistent with its original intent. It is a necessary feature within the framework of exchange-traded options to maintain contract integrity and protect both option holders and writers.
History and Origin
The concept of adjusting options contracts evolved alongside the standardization of options trading. Before the advent of organized options exchanges, options were primarily traded over-the-counter with bespoke terms, making adjustments a bilateral agreement between parties. The establishment of the Chicago Board Options Exchange (CBOE) in 1973 marked a pivotal moment, as it introduced standardized options with a central clearinghouse, the Options Clearing Corporation (OCC). This standardization required a clear process for handling corporate events. The OCC became the central authority responsible for determining and implementing these adjustments to ensure fairness and maintain an orderly market. Ea44rly on, options contracts typically covered 100 shares of the underlying security, but corporate actions necessitated a formal mechanism to alter these terms when required.
#43# Key Takeaways
- An Adjusted Gross Option is an options contract that has been modified due to a corporate action affecting the underlying asset.
- The Options Clearing Corporation (OCC) is the primary entity responsible for determining and implementing these adjustments.
- Adjustments can involve changes to the number of shares per contract, the strike price, or the type of deliverable.
- These adjustments aim to preserve the original economic value of the option for both buyers and sellers.
- Common corporate actions leading to adjustments include stock splits, mergers, special dividends, and spin-offs.
Formula and Calculation
While there isn't a single universal "Adjusted Gross Option" formula, the adjustments made to an options contract following a corporate action are precise and depend on the specific event. The OCC publishes memos detailing these adjustments. For example, in a stock split, the strike price and the number of contracts or shares per contract are adjusted.
For a stock split:
If a company announces a 2-for-1 stock split:
Original Contract: 1 call option to buy 100 shares at a strike price of $50.
New Adjustment: The holder will now have 2 call options, each for 100 shares, at a strike price of $25.
Alternatively, for a different type of split or a reverse stock split, the number of shares deliverable per contract might change while the aggregate exercise value remains the same.
For example, if a 1-for-2 reverse stock split occurs, and an option previously represented 100 shares at a $100 strike:
Original Aggregate Exercise Value = ( \text{100 shares} \times $100/\text{share} = $10,000 )
After a 1-for-2 reverse stock split, the option would adjust. While the strike price might remain unchanged, the number of shares deliverable would be halved.
New Deliverable: 50 shares
New Aggregate Exercise Value = ( \text{50 shares} \times $200/\text{share (new price)} = $10,000 )
This ensures the total value associated with exercising the option remains the same. The exercise price is modified to reflect the change in the underlying shares' value.
Interpreting the Adjusted Gross Option
Interpreting an Adjusted Gross Option primarily involves understanding the specific modifications applied to the contract. When a corporate action occurs, the OCC issues an "adjustment memo" that outlines the new terms. In41, 42vestors need to review these memos carefully to understand how the option's value and deliverable have been altered. For instance, a cash dividend might lead to a reduction in the strike price of a call option, reflecting the cash distributed to shareholders of the underlying security. Conversely, a stock split or reverse stock split will directly impact the number of shares represented by each contract or the strike price, maintaining the total notional value. Understanding these adjustments is crucial for evaluating the option's value and planning subsequent trading decisions.
Hypothetical Example
Consider an investor holding one call option contract for Company A, with a strike price of $100 and an expiration in three months. Each contract represents 100 shares.
Company A announces a 2-for-1 stock split.
Before the adjustment:
The investor has the right to buy 100 shares of Company A at $100 per share.
Following the 2-for-1 stock split, the OCC will adjust the option contract.
After the adjustment:
The investor will now hold two call option contracts for Company A.
Each of these new contracts will have a strike price of $50.
Each contract will still represent 100 shares.
The total number of shares the investor can control remains 200 (2 contracts * 100 shares/contract), and the aggregate exercise cost remains the same ($100 * 100 shares = $10,000, now 2 contracts * $50 * 100 shares = $10,000). This adjustment ensures the investor's original economic exposure is preserved despite the change in the stock's per-share value due to the corporate action.
Practical Applications
Adjusted Gross Options are encountered primarily in the context of options trading and portfolio management, especially when dealing with derivative instruments tied to equities. They are a practical necessity in maintaining fair and orderly markets. For example, when a company undergoes a merger or acquisition, the underlying shares of the acquired company may cease to exist. In such cases, the options on that company's stock would be adjusted, often becoming "cash-settled" or referencing shares of the acquiring entity. Si40milarly, special cash dividends, which are not part of a regular dividend policy, can trigger adjustments to options contracts to ensure that the option holder is not disadvantaged or unfairly advantaged by the underlying stock's price reduction due to the dividend payout. Th39e Options Clearing Corporation (OCC) serves as the guarantor for all listed options in the U.S. and plays a vital role in standardizing and managing these adjustments, ensuring consistency across the market. In38vestors can verify specific adjustments by searching the OCC website.
#37# Limitations and Criticisms
While necessary for maintaining market integrity, Adjusted Gross Options can sometimes introduce complexities for individual investors. The primary limitation lies in the potential for non-standard contract terms. While the OCC strives for a fair adjustment that preserves the original economic value of the option, the resulting adjusted contract might be for an unusual number of shares or include a cash component, making it less liquid or harder to trade than a standard contract. Th36is can be particularly challenging for retail investors who may be accustomed to the simpler, standardized 100-share contracts.
Furthermore, these adjustments can sometimes lead to reduced trading volume for the adjusted series, as market makers may offer wider bid-ask spreads due to the non-standard nature of the contract, potentially making it more difficult to exit positions at favorable prices. Al35though the system aims for fairness, the nuances of some adjustments can be difficult for less experienced investors to fully grasp, potentially leading to confusion regarding the true value or implications of their adjusted options. Understanding how liquidity can be impacted is key for options traders.
Adjusted Gross Option vs. Employee Stock Option
An Adjusted Gross Option refers to the modification of an existing, often exchange-traded, options contract to account for corporate actions affecting the underlying security. Its purpose is to preserve the economic value of the contract when the underlying asset's structure changes.
In contrast, an Employee Stock Option (ESO) is a form of equity compensation granted by an employer to an employee. It gives the employee the right to purchase the company's stock at a predetermined price (the grant or strike price) at a future date. ES34Os are typically part of an employee's compensation package and are governed by specific vesting schedules and tax rules, such as those for incentive stock options (ISOs) or non-qualified stock options (NSOs). Wh31, 32, 33ile both involve options, the Adjusted Gross Option is about the post-issuance modification of a derivative contract due to market events, whereas an Employee Stock Option is a mechanism for employee compensation and ownership.
FAQs
What types of corporate actions lead to an Adjusted Gross Option?
Adjusted Gross Options typically arise from corporate actions such as stock splits (forward or reverse), special cash dividends, stock distributions, mergers, acquisitions, spin-offs, and rights offerings. Re29, 30gular cash dividends generally do not trigger adjustments.
#28## Who determines the adjustments for an Adjusted Gross Option?
In the United States, the Options Clearing Corporation (OCC) is responsible for determining and implementing adjustments to options contracts following corporate actions. The OCC issues official memos detailing these changes.
#26, 27## Can an Adjusted Gross Option have a different number of shares than a standard contract?
Yes, depending on the corporate action, an Adjusted Gross Option can represent a different number of underlying shares than the standard 100 shares per contract. It might also include a cash component as part of the deliverable.
#25## How do I find information about a specific Adjusted Gross Option?
Information regarding specific Adjusted Gross Options and their adjustments can typically be found on the Options Clearing Corporation (OCC) website through their corporate action memos. Yo24ur brokerage firm should also provide details on any adjustments to your holdings.
Does an Adjusted Gross Option impact the original value of my investment?
The goal of adjusting an options contract is to preserve the intrinsic economic value of the original option position. While the terms (strike price, number of shares) may change, the intention is to ensure that the holder or writer is in the same economic position as before the corporate action.[^123^](https://www.merrilledge.com/investment-products/options/adjusted-options-contracts)[2](https://help.firstrade.info/en/articles/9264937-when-are-adjustments-made-to-option-contracts)[3](https://www.theocc.com/clearance-and-settlement/clearing/equity-options-product-specifications)[4](https://www.merrilledge.com/investment-products/options/adjusted-options-contracts), 567, 89, 10, 111213141516171819, 202122