What Is Adjusted Option?
An adjusted option is an options contract whose terms have been modified by a clearing organization, typically the Options Clearing Corporation (OCC), in response to a corporate action affecting the underlying security. These modifications ensure that the economic value of the contract is preserved for both the holder and the writer following events such as a stock split, special dividends, or mergers and acquisitions. Adjusted options fall under the broader category of financial derivatives, as their value is derived from an underlying asset. When an adjustment occurs, elements of the original option, such as the number of shares represented, the strike price, or even the deliverable asset, may change. An adjusted option is often referred to as a "non-standard" option due to these altered terms.
History and Origin
The concept of adjusting options contracts evolved alongside the growth and standardization of the options market. Before the establishment of regulated exchanges, options were often traded over-the-counter (OTC) with less formal adjustment mechanisms. The landscape of options trading significantly changed with the founding of the Chicago Board Options Exchange (CBOE) in 1973, which introduced standardized, exchange-traded options5. This standardization necessitated a formal process for handling corporate actions to maintain fair and orderly markets. The Options Clearing Corporation (OCC), established in 1973 as the sole clearing agency for listed options in the U.S., plays a pivotal role in this process. The OCC's By-Laws and Rules authorize it to make adjustments to listed options when certain events, such as stock dividends, stock distributions, or reorganizations, occur with respect to the underlying security. This ensures consistency and fairness across all affected contracts4.
Key Takeaways
- An adjusted option is an existing options contract whose terms are modified due to a corporate action affecting the underlying security.
- The Options Clearing Corporation (OCC) is responsible for determining and implementing these adjustments to preserve the contract's economic value.
- Common corporate actions leading to adjustments include stock splits, special dividends, and mergers.
- Adjustments can alter the number of shares represented by the contract, the strike price, or the nature of the deliverable.
- Adjusted options typically have reduced liquidity compared to standard options.
Interpreting the Adjusted Option
Interpreting an adjusted option requires careful attention to the specific changes made to its original terms. The primary goal of an adjustment is to ensure that the aggregate market value of the option position remains relatively consistent with its pre-adjustment value, reflecting the changes in the underlying security. For instance, in a stock split, while the stock price decreases, the number of shares per option contract or the number of contracts held will be adjusted upwards to compensate.
Traders and investors must consult the official information memos issued by the Options Clearing Corporation (OCC) for precise details regarding any adjustment. These memos outline the revised strike price, the new number of shares per contract, or any changes to the deliverable. Understanding these changes is crucial for assessing the new breakeven points, potential profits, and losses, and for making informed decisions regarding exercising, selling, or holding the adjusted option. This proactive approach is a vital component of effective risk management in derivatives trading.
Hypothetical Example
Consider an investor who owns one XYZ Inc. call option with a strike price of $100 and an expiration date in three months, representing 100 shares. Suppose XYZ Inc. announces a 2-for-1 stock split.
Before the split, the option gives the right to buy 100 shares of XYZ at $100 per share.
After the 2-for-1 stock split, the Options Clearing Corporation (OCC) would adjust the option. Instead of one contract for 100 shares, the investor might now hold two adjusted options contracts, each representing 100 shares, but with a new strike price of $50 per share. Alternatively, the OCC might adjust the original contract to represent 200 shares at the adjusted strike price of $50. The exact adjustment varies based on the OCC's determination for that specific corporate action. In either scenario, the total intrinsic value of the position remains the same:
- Original: 100 shares * $100/share = $10,000 potential purchase.
- Adjusted (two contracts): 200 shares * $50/share = $10,000 potential purchase.
- Adjusted (one contract with altered shares): 200 shares * $50/share = $10,000 potential purchase.
This adjustment ensures that the investor's original economic exposure to XYZ Inc. through the option is maintained despite the change in the underlying stock's structure.
Practical Applications
Adjusted options are a critical component of maintaining fairness and continuity in financial markets when corporate actions occur. Their primary application is to normalize options contracts following events that alter the underlying stock's value or structure. For instance, when a company undergoes a stock split, like Apple and Tesla did in 2020, the options on these companies were adjusted to reflect the new share count and price per share, ensuring that existing option holders were not unfairly disadvantaged or advantaged3.
Furthermore, understanding adjusted options is crucial for investors and traders involved in complex options strategies. It impacts everything from calculating profit and loss to managing the tax implications of exercising or closing an adjusted contract. The Internal Revenue Service (IRS) provides guidance on the taxation of investment income and expenses, including options, in publications such as IRS Publication 550, which details how gains and losses from options trading are treated for tax purposes2.
Limitations and Criticisms
While necessary for maintaining fairness, adjusted options come with certain limitations and criticisms. One significant drawback is the potential for reduced liquidity. Because an adjusted option no longer conforms to the standardized contract specifications, it may trade less frequently than newly issued, standard options on the same underlying security. This can make it harder for investors to enter or exit positions at desirable prices.
Another criticism revolves around the complexity that adjusted options introduce. Their non-standard nature can be confusing for less experienced traders, leading to potential misunderstandings about the contract's new terms, such as the altered strike price or adjusted deliverable. While the Options Clearing Corporation (OCC) strives for fairness in its adjustments, the specific mechanics can sometimes vary depending on the nature of the corporate action, requiring careful review of OCC information memos1. The unique nature of each adjusted option can also complicate pricing models and make it challenging to compare them with standard options.
Adjusted Option vs. Standard Option
The key distinction between an adjusted option and a standard option lies in the modification of their original contract terms. A standard option is a contract with fixed, standardized terms, including a specific strike price, expiration date, and a fixed multiplier (typically representing 100 shares of the underlying asset). These terms remain constant throughout the option's life unless a corporate action necessitates a change.
Conversely, an adjusted option is a standard option whose terms have been modified by a clearing organization due to a corporate action, such as a stock split or a merger. These adjustments aim to preserve the original economic value of the contract. For example, if a company undergoes a 2-for-1 stock split, a standard call option that previously controlled 100 shares at a $100 strike might become an adjusted option controlling 200 shares at a $50 strike (or two contracts controlling 100 shares each at $50). This alteration makes the adjusted option "non-standard," often resulting in lower trading volume and less liquidity compared to its standard counterparts.
FAQs
What causes an option to become an Adjusted Option?
An option becomes an adjusted option due to a corporate action taken by the company whose stock is the underlying asset of the option. Common corporate actions include stock splits, special cash or stock dividends, mergers, acquisitions, and spin-offs.
Who determines the adjustments made to an option contract?
The Options Clearing Corporation (OCC), which is the primary clearinghouse for listed options in the U.S., determines and implements the adjustments to options contracts following corporate actions. They issue specific information memos detailing the changes.
How does an Adjusted Option affect its trading?
Adjusted options often have lower liquidity and trading volume compared to standard options. This is because their modified terms make them unique and less appealing to the broader market, which prefers the simplicity and standardization of regular contracts.
Are Adjusted Options more complex to understand?
Yes, adjusted options can be more complex due to their non-standard terms. Investors need to carefully review the specific adjustments made to the strike price, number of deliverable shares, or other contract specifications as outlined by the OCC to fully understand their implications.