Adjusted long term option

What Is Adjusted Long-Term Option?

An Adjusted Long-Term Option refers to an options contract whose original terms have been modified by a clearinghouse in response to a corporate actions event concerning the underlying security. These modifications are necessary to ensure that the economic value of the option is preserved for both the holder and the writer, despite changes to the underlying asset. This concept falls under the broader category of derivatives and options trading. Common corporate actions that trigger such adjustments include stock splits, mergers and acquisitions, special dividends, and spin-offs. An Adjusted Long-Term Option ensures that the initial intent and value of the contract remain intact after these significant corporate events.

History and Origin

The need for adjusting options contracts arose with the standardization and widespread listing of options trading. Before the establishment of a centralized clearing entity, managing such changes was complex and inconsistent. The Options Clearing Corporation (OCC), founded in 1973, became the world's largest equity derivatives clearing organization, responsible for standardizing and clearing options contracts in the U.S. financial markets.,

The OCC's role is critical in determining how outstanding options contracts are adjusted following corporate actions. When a company announces an event like a stock split or a special dividend, the OCC publishes an information memo detailing the specific adjustments to be made to existing options series. This ensures a consistent and fair approach across the market. The evolution of options trading and the increasing complexity of corporate structures necessitated a robust mechanism to maintain the integrity of options positions, leading to the formalized process of adjusting options contracts as overseen by the OCC. The U.S. Securities and Exchange Commission (SEC) also plays a role in overseeing the rules governing exchanges and clearinghouses, which can include how options are adjusted.⁷

Key Takeaways

• An Adjusted Long-Term Option is an options contract whose terms (e.g., strike price, number of shares, contract multiplier) have been modified due to a corporate action affecting the underlying security.
• The Options Clearing Corporation (OCC) is the primary body responsible for determining and implementing these adjustments to maintain the economic equivalence of the original contract.
• Adjustments are triggered by events such as stock splits, mergers, special dividends, and spin-offs.
• Adjusted options may exhibit reduced liquidity compared to standard options due to their non-standard terms.
• It is crucial for traders and investors to understand how corporate actions impact their existing options positions.

Interpreting the Adjusted Long-Term Option

Interpreting an Adjusted Long-Term Option requires careful attention to the specific modifications made to the contract. Unlike standard options that uniformly cover 100 shares of an underlying asset at a given strike price, an adjusted option might represent a different number of shares, include cash, or have a modified strike price. The adjustments are designed to preserve the total value of the original option position. For instance, if a stock undergoes a 2-for-1 split, an existing option contract for 100 shares at a $50 strike price might be adjusted to two contracts for 100 shares each, but with a new strike price of $25 per share. The total underlying value ($50 x 100 shares = $5,000 before, and $25 x 200 shares = $5,000 after) remains consistent.

Investors must consult the official memos issued by the Options Clearing Corporation (OCC) to understand the exact terms of the adjusted option. These memos detail changes to the deliverable, strike price, and potentially the contract multiplier or even the expiration date.⁶ Without this detailed information, it is impossible to accurately assess the value or potential outcome of an adjusted option. Understanding these changes is vital for proper risk management and trade execution.

Hypothetical Example

Consider an investor holding a call options contract for XYZ Corp. with a strike price of $100, set to expire in six months. The option represents 100 shares of XYZ.

Suppose XYZ Corp. announces a 2-for-1 stock split. This means that for every one share of XYZ an investor owns, they will now own two, and the price per share will be halved.

Here's how the Adjusted Long-Term Option would likely be affected:

1. Original Contract: 1 XYZ Call, Strike $100, covering 100 shares.
2. Corporate Action: 2-for-1 Stock Split by XYZ Corp.
3. OCC Adjustment: The Options Clearing Corporation (OCC) would typically adjust this contract to preserve its value. The adjustment might result in:
   • New Number of Contracts: The original single contract might be adjusted to two contracts.
   • New Strike Price: The strike price of each new contract would be halved, from $100 to $50.
   • Shares per Contract: Each of the two new contracts would still represent 100 shares of XYZ.

So, the investor who originally held one contract for 100 shares at a $100 strike price would now hold two contracts, each for 100 shares, with a strike price of $50. The total value represented by the options remains equivalent to the original position, as the right to buy 100 shares at $100 is economically similar to the right to buy 200 shares at $50 (across two contracts). This adjustment aims to ensure fair treatment of option holders and writers following significant changes to the underlying equity.

Practical Applications

Adjusted Long-Term Options appear in various practical scenarios within financial markets, primarily when corporate actions impact the equities on which options are traded.

• Portfolio Management: Fund managers and individual investors holding significant options positions must be aware of potential adjustments. These adjustments directly alter the characteristics of their existing contracts, influencing strategy and risk exposure. For example, if a portfolio contains put options that become adjusted, the new terms need to be factored into overall portfolio risk management.
• Arbitrage and Hedging: Professionals engaging in arbitrage or complex hedging strategies use the knowledge of option adjustments to manage their positions. They rely on the predictability of OCC adjustments to maintain their desired risk profiles, especially when implementing strategies that involve multiple legs affected by the same corporate action.
• Regulatory Compliance: Brokerage firms and clearing members need to ensure their systems accurately reflect adjusted option terms to comply with regulatory requirements set by bodies like the SEC. The Options Clearing Corporation (OCC) provides official guidance through information memos, which are critical for market participants to adhere to. The Cboe, for instance, explicitly states that strike prices are adjusted for splits and recapitalizations in its equity options product specifications.⁵
• Market Data Providers: Data vendors and financial information services must constantly update their databases to reflect adjusted option chains. This ensures that traders and analytical tools have access to accurate pricing and contract specifications for these non-standard options.

Limitations and Criticisms

While the adjustment process for an Adjusted Long-Term Option aims to preserve economic value, there are certain limitations and criticisms associated with them.

One significant drawback is the potential for reduced liquidity. Adjusted options, sometimes referred to as "non-standard options," often trade with lower trading volume and open interest compared to their standard counterparts.⁴ This can make it more challenging for investors to enter or exit positions at desirable prices, as wider bid-ask spreads may occur. The complexity arising from altered contract terms can deter some market participants, leading to a less active market for these specific series.

Another criticism pertains to the potential for confusion among less experienced investors. Understanding how a corporate action, such as a special cash dividend or a spin-off, translates into an adjustment of an option premium, strike price, or deliverable can be challenging. While the Options Clearing Corporation (OCC) publishes detailed memos, investors must proactively seek out and interpret this information. This complexity can lead to misunderstandings or unintended outcomes if not properly managed. The Options Industry Council (OIC) offers educational resources to help investors navigate these complexities.³

Furthermore, in some instances, even with adjustments, the precise economic equivalence might not be perfectly maintained, especially in cases involving complex corporate restructurings or unique deliverables. While the OCC strives for fairness, there can be subtle differences in how a position behaves post-adjustment, particularly concerning factors like implied volatility or pricing models.

Adjusted Long-Term Option vs. Non-Standard Option

The terms "Adjusted Long-Term Option" and "Non-Standard Option" are often used interchangeably, and for most practical purposes, an Adjusted Long-Term Option is a type of non-standard option. However, a subtle distinction can be made in the emphasis of the terms:

An Adjusted Long-Term Option specifically highlights the fact that a standard option contract, which was initially listed with conventional terms, has undergone a modification due to a corporate event. The "long-term" aspect simply refers to the option's original time horizon before the adjustment. A Non-Standard Option is a broader umbrella that includes all options that deviate from the standard 100-share deliverable and round-number strike prices, whether due to an adjustment or being initially listed as such (e.g., options on exchange-traded funds with non-standard units or special "mini" options). Therefore, all Adjusted Long-Term Options are non-standard, but not all non-standard options are necessarily adjusted long-term options.

FAQs

Why do options contracts get adjusted?

Options contracts get adjusted to ensure that their economic value is preserved when the underlying security undergoes significant changes due to corporate actions. Without adjustments, events like stock splits or special dividends would unfairly benefit one side of the contract (either the buyer or the seller) at the expense of the other. The adjustments aim to keep the option's intrinsic value and overall exposure consistent with the original terms.

Who is responsible for adjusting options contracts?

In the United States, the Options Clearing Corporation (OCC) is primarily responsible for determining and implementing adjustments to listed options contracts following corporate actions. The OCC issues official memos detailing the specific changes to be made to the strike price, deliverable, or other terms of affected options contract series.

How can I tell if an option has been adjusted?

An adjusted option often has a different symbol than the standard options chain for the same underlying security, sometimes including a numerical suffix (e.g., XYZ1 instead of XYZ).² Additionally, the number of shares per contract or the strike price might appear unusual compared to standard option intervals. The most reliable way to confirm an adjustment and understand its exact terms is to consult the information memos published on the Options Clearing Corporation's (OCC) official website.

Are regular cash dividends cause for option adjustment?

Generally, no. Regular, ordinary cash dividends do not typically trigger adjustments to options contracts. Options are usually only adjusted for "non-ordinary" cash dividends, which are often large, one-time, or special payouts that significantly impact the underlying stock's price. The determination of whether a dividend is "ordinary" or "non-ordinary" is made by the Options Clearing Corporation (OCC).¹