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

What Is an Adjusted Market Option?

An Adjusted Market Option refers to an existing options contract whose terms have been modified from its original specifications due to a corporate action affecting the underlying asset. These adjustments are made to ensure that the economic value of the options contract remains consistent and fair to both the option buyer and seller, despite changes to the underlying security. This concept falls under the broader category of Options Trading, a field within derivatives that involves financial contracts deriving their value from an underlying asset. When an underlying asset undergoes events such as stock splits, dividends (specifically special or extraordinary dividends), or mergers, the original terms of the Adjusted Market Option—like its strike price or the number of shares it represents—are amended.

History and Origin

The necessity for Adjusted Market Options emerged alongside the development of organized options markets. As options trading became more widespread, a standardized mechanism was required to handle the impact of corporate actions on existing contracts. Without such adjustments, a corporate event like a stock split could unfairly enrich or disadvantage option holders and writers. To maintain market integrity and fairness, clearing organizations established protocols for these adjustments. For instance, the Options Clearing Corporation (OCC) plays a crucial role in determining and implementing these changes for U.S. options, ensuring that outstanding contracts are properly modified in response to corporate events. Thi¹³s process is essential to preserve the original economic intent of the option agreement.

Key Takeaways

An Adjusted Market Option is an options contract modified due to a corporate action affecting its underlying asset.
Adjustments aim to preserve the economic value and fairness of the option for both buyers and sellers.
Common corporate actions leading to adjustments include stock splits, special dividends, and mergers.
The Options Clearing Corporation (OCC) typically oversees and determines the terms of these adjustments.
Adjusted options can sometimes exhibit lower liquidity due to their non-standardized nature.

Formula and Calculation

While there isn't a single universal "formula" for an Adjusted Market Option's value, the adjustment process itself often involves recalculating the strike price or the number of deliverable shares. The goal is to keep the total aggregate value of the option position equivalent to its value before the corporate action.

For a stock split:
If a company announces an (N)-for-(M) stock split (e.g., 2-for-1 split where (N=2), (M=1)), the adjusted strike price ((S_{adj})) and the adjusted number of shares per contract ((Shares_{adj})) are typically calculated as follows:

S_{adj} = S_{original} \times \frac{M}{N} \\ Shares_{adj} = Shares_{original} \times \frac{N}{M}

Where:

(S_{original}) = The original strike price of the option.
(Shares_{original}) = The original number of shares represented by one option contract (typically 100).
(N) = The number of new shares received.
(M) = The number of old shares held.

For example, a 2-for-1 split would halve the strike price and double the number of shares represented by the contract. Conversely, a reverse stock split would involve increasing the strike price and reducing the number of shares per contract. In the case of a special cash dividend, the strike price may be reduced by the dividend amount per share to account for the loss of value in the underlying asset.

Interpreting the Adjusted Market Option

Interpreting an Adjusted Market Option requires careful attention to the specific changes made to its terms. Unlike standard options, an adjusted option might have an unusual strike price (e.g., a fractional strike price) or represent a different number of shares than the typical 100. Tra¹²ders must consult the official notices issued by the relevant clearing corporation (like the OCC) to understand the exact adjustments. Failure to do so can lead to misinterpretations of the option's true value, its expiration date, and its potential payoff. An adjusted option will often be flagged with a special symbol in trading platforms to indicate its non-standard nature. Investors employing hedging strategies need to understand these adjustments to ensure their positions continue to provide the intended protection.

Hypothetical Example

Consider an investor holding one call option for Company ABC with a strike price of $50, expiring in three months. Each option contract represents 100 shares.

Suppose Company ABC announces a 2-for-1 stock split. Before the split, the investor's call option gave them the right to buy 100 shares at $50 per share.

Following the adjustment by the Options Clearing Corporation:

The original $50 strike price will be adjusted to $25 (($50 \times \frac{1}{2})).
The number of shares represented by the contract will change from 100 to 200 ((100 \times \frac{2}{1})).

The investor now holds one Adjusted Market Option for Company ABC, giving them the right to buy 200 shares at $25 per share. The total notional value remains the same: 100 shares * $50/share = $5,000, and 200 shares * $25/share = $5,000. This ensures the economic value of the options contract is preserved, even though its parameters have changed.

Practical Applications

Adjusted Market Options are a critical component of maintaining fairness and continuity in the options market, particularly when corporate action events occur. They show up in several practical applications:

Fairness in Trading: They ensure that investors who bought or sold options before a corporate event are not unfairly penalized or advantaged by the change.
Portfolio Management: Fund managers and individual investors need to understand how their existing option positions will be impacted by adjustments for effective risk management. This is crucial for strategies involving put options or call options.
Market Integrity: The systematic process of adjusting options contributes to the overall stability and reliability of the financial markets, allowing for continuity even when underlying securities undergo significant structural changes.
Customized Strategies: While "Adjusted Market Option" refers to modifications of existing contracts due to corporate events, the broader market also offers highly customized or "bespoke" options, such as Flexible Exchange (FLEX) Options, which allow for tailored terms from inception. The¹¹ ¹⁰se enable traders to create specific strategies not available with standardized contracts.

##⁹ Limitations and Criticisms

While necessary for market fairness, Adjusted Market Options can introduce complexities and limitations:

Reduced Liquidity: Adjusted options are often considered "non-standard" and may trade with significantly lower volume and open interest compared to their standardized counterparts. Thi⁸s can make it challenging for investors to easily buy or sell these contracts, potentially leading to wider bid-ask spreads and less favorable execution prices.
Complexity: The calculation and implications of adjustments can be intricate, particularly for complex corporate actions like spin-offs or certain mergers. Investors must diligently consult official sources like the Options Clearing Corporation (OCC) notices to fully understand the revised terms.
⁷ Pricing Discrepancies: Due to lower liquidity and the unique terms, pricing for adjusted options might occasionally appear inconsistent with market expectations, requiring sophisticated analysis.
Exercise and Assignment: The exercise and assignment processes for adjusted options might differ from standard options, requiring extra attention from traders. Investors should always refer to official disclosure documents outlining the risks and characteristics of options.

##⁶ Adjusted Market Option vs. Bespoke Option

The terms "Adjusted Market Option" and "Bespoke Option" both refer to options contracts that deviate from typical standardized exchange-traded options, but they differ significantly in their origin and purpose.

Feature	Adjusted Market Option	Bespoke Option (e.g., OTC Option, FLEX Option)
Origin	An existing, initially standardized option contract that has its terms modified in response to a corporate action (e.g., stock split, special dividend).	A⁵ new option contract customized from its inception to meet specific investor needs, typically traded over-the-counter (OTC) or as a Flexible Exchange (FLEX) option.
⁴ Purpose	To preserve the economic value and fairness of outstanding option contracts after a corporate event.	To provide investors with greater flexibility in terms of strike price, expiration date, contract size, or other terms not available in standardized options.
Standardization	Becomes non-standard after adjustment, potentially losing liquidity.	Is non-standard by design, offering tailored solutions.
Market	Trades on the same exchange but with modified terms; can experience reduced liquidity.	Often traded bilaterally in the OTC market or on exchanges that offer customization (e.g., Cboe's FLEX Options).

³The key distinction lies in why the option deviates from standard terms. An Adjusted Market Option is a reactive change to maintain parity, while a Bespoke Option is a proactive creation designed for specific strategic objectives.

FAQs

How do I know if an option contract has been adjusted?

Trading platforms typically indicate an adjusted option with a special symbol, such as an "A" next to the ticker, or by a non-standard strike price or share multiplier. Alw²ays consult the official announcements from the clearing corporation, like the Options Clearing Corporation (OCC), for precise details of the adjustment.

Are adjustments common for all corporate actions?

Adjustments are specifically made for corporate actions that materially affect the value or structure of the underlying security, such as stock splits, reverse stock splits, large special dividends, and certain mergers or spin-offs. Ordinary quarterly cash dividends typically do not lead to options adjustments.

Can I still trade an Adjusted Market Option?

Yes, Adjusted Market Options can still be traded on the exchange. However, due to their non-standard nature, they may have lower liquidity and wider bid-ask spreads, making them potentially more challenging to trade than standardized options.

What are the risks associated with Adjusted Market Options?

The primary risks include reduced liquidity, which can make it difficult to enter or exit positions at desired prices, and increased complexity in understanding the modified terms. Inv¹estors must be diligent in verifying the new strike price and other parameters to avoid misjudging the option's value.