Adjusted options: Meaning, Criticisms & Real-World Uses

What Are Adjusted Options?

Adjusted options are options contracts whose terms have been modified by a clearing organization, typically The Options Clearing Corporation (OCC) in the United States, to account for certain corporate actions by the underlying asset's issuer. These adjustments are a critical component of derivatives markets, ensuring fairness and continuity for option holders when significant events occur with the shares that the options represent. Without such adjustments, the economic value of an options contract could be drastically altered or lost due to events outside the control of the option holder. Adjusted options are sometimes referred to as "packaged options" or "non-standard options."¹⁷

History and Origin

The need for adjusted options arose with the standardization and widespread trading of options contracts. As corporate actions like stock splits, mergers, acquisitions, and dividends became common occurrences in public companies, it became necessary to establish a consistent framework for how existing options contracts would be affected. The Options Clearing Corporation (OCC), established in 1973, plays a central role in this process in the U.S., acting as the guarantor and clearinghouse for listed options. The OCC’s bylaws and interpretative guidance dictate how and when adjustments are made to preserve the economic value of options positions across these events. For example, the Federal Register published a notice regarding an OCC rule change concerning interpretative guidance on contract adjustments for cash dividends and distributions, illustrating the ongoing evolution and formalization of these processes.

¹⁶## Key Takeaways

Adjusted options result from modifications to existing options contracts due to corporate actions affecting the underlying asset.
The primary goal of adjustments is to preserve the intrinsic value of the options, aiming to keep option holders in a similar economic position before and after the corporate event.
*¹⁵ Common events triggering adjustments include stock splits, reverse splits, special cash dividends, mergers, acquisitions, and spin-offs.
Adjustments can alter the strike price, the number of shares deliverable per contract, or even change the underlying asset itself.
*¹⁴ Adjusted options may experience reduced liquidity in the market compared to standard options due to their non-standard terms.

¹³## Formula and Calculation

While there isn't a single universal "formula" for all adjusted options, the principle behind the adjustments for events like stock splits is to maintain the overall value of the options contract. The strike price and the number of underlying asset shares represented by the contract are typically modified proportionally.

For a forward stock split (e.g., a 2-for-1 split), if the original contract covers (N_0) shares at a strike price of (S_0), and the split ratio is (n) new shares for (m) old shares (e.g., for a 2-for-1 split, (n=2, m=1)), the adjustment would generally be:

New Shares Per Contract ((N_1)):
$N_1 = N_0 \times \frac{n}{m}$

New Strike Price ((S_1)):
$S_1 = S_0 \times \frac{m}{n}$

The total value represented by the contract, (N \times S), aims to remain constant or as close as possible before and after the adjustment. Similarly, for a special cash dividend, the strike price of the option may be reduced by the amount of the dividend per share to maintain parity.

¹²## Interpreting Adjusted Options

Interpreting adjusted options requires careful attention to the specific terms outlined in the adjustment memo issued by the OCC or relevant clearing organization. Unlike standard options contracts which typically represent 100 shares of the underlying asset and have round strike prices, adjusted options can have non-standard share deliverables (e.g., 33 shares, or 100 shares of one company plus 50 shares of another) or unusual strike prices (e.g., $47.33).

¹¹When evaluating adjusted options, it is crucial for investors to consult the official information memos detailing the precise changes to the contract specifications, including the new strike price, the new number of deliverable shares, and any change in the underlying asset. These modifications directly impact the option's intrinsic value and how it might be exercised or assigned. Understanding the adjustment is essential for accurately assessing the risk and reward profile, as well as for determining how the option might behave with changes in implied volatility or the price of the new underlying asset.

Hypothetical Example

Consider an investor who holds a call options contract on Company XYZ, with an expiration date of September and a strike price of $50. This contract typically represents 100 shares of XYZ.

Suppose Company XYZ announces a 3-for-2 stock split. This means for every 2 shares owned, shareholders will receive 3 new shares. The strike price and the number of deliverable shares for existing options contracts will be adjusted by the OCC.

Original Contract:

Shares per contract: 100
Strike price: $50

After a 3-for-2 split, the adjustment factors are: (n=3, m=2).

New Shares Per Contract:
$100 \text{ shares} \times \frac{3}{2} = 150 \text{ shares}$

New Strike Price:
$\$50 \times \frac{2}{3} \approx \$33.33$

The original options contract would be adjusted to represent 150 shares of Company XYZ at a strike price of approximately $33.33. This adjustment is designed to ensure that the total value of shares the option holder has the right to buy (or sell for a put option) remains consistent, preventing an arbitrary gain or loss solely from the corporate actions. The investor now holds an adjusted option with new, non-standard terms within the options chain.

Practical Applications

Adjusted options are primarily a mechanism for maintaining market integrity and investor fairness in the face of corporate actions. Their practical applications are seen in several areas of financial markets:

Risk Management: For portfolio managers engaged in hedging strategies, adjustments ensure that their options positions continue to provide the intended risk offset even if the underlying asset undergoes a major change.
Fair Value Preservation: Clearing organizations ensure that the economic value of options contracts is preserved. This is crucial for both option buyers and sellers, preventing unforeseen windfalls or losses that could arise from changes in the underlying asset's structure.
Market Continuity: By adjusting existing contracts, the market avoids the need to cancel and re-issue all outstanding options every time a corporate action occurs, promoting smoother operation.
Arbitrage Prevention: Adjustments help to prevent arbitrage opportunities that might arise if the value of options did not accurately reflect the changes in the underlying asset following a corporate action.

These adjustments are a standard part of how derivatives markets operate globally, ensuring consistency for participants. For instance, the National Stock Exchange of India (NSE) outlines similar principles for adjusting options contracts due to corporate actions, aiming to keep the value of positions unchanged.

¹⁰## Limitations and Criticisms

Despite their purpose of fairness, adjusted options can present certain limitations and criticisms for market participants:

Reduced Liquidity: Adjusted options often trade with significantly lower liquidity compared to standard options. Their non-standard deliverable sizes or strike prices mean fewer market participants are interested in trading them, leading to wider bid-ask spreads and potentially making it harder to enter or exit positions.
*⁹ Complexity: The non-standard terms of adjusted options can be confusing, especially for less experienced traders. Understanding how a corporate action impacts a specific options contract requires consulting detailed adjustment memos, which adds a layer of complexity to position management.
Price Discovery Challenges: With lower trading volume, the price discovery process for adjusted options can be less efficient. This might lead to prices that do not always perfectly reflect the true fair value, even with the intention of value preservation.
Discretionary Adjustments: While clearinghouses like the OCC have established bylaws, some adjustments, particularly for certain types of dividends, can involve discretion. This lack of fully standardized treatment can introduce uncertainty for investors.

⁸These factors mean that while adjustments aim to prevent major disruptions, they can introduce practical challenges for traders and investors.

Adjusted Options vs. Standard Options

The key distinction between adjusted options and standard options lies in their contract specifications and the events that lead to their formation.

Feature	Standard Options	Adjusted Options
Contract Terms	Typically standardized (e.g., 100 shares per contract, round strike price multiples).	Non-standard strike price, non-standard number of shares, or altered underlying asset due to a corporate action.
Origin	Issued as new contracts on an options exchange with predefined terms.	Existing standard options that have undergone modification by a clearing organization due to a corporate action.
Liquidity	Generally higher due to broad market interest and standardized terms.	Often lower, as their unique terms can deter some market participants, leading to wider bid-ask spreads.
Tradability	Actively traded in the options chain for most listed securities.	May continue to trade but often with reduced volume; sometimes new, standard options are issued for the same underlying asset alongside them.
Complexity	Relatively straightforward; terms are consistent.	More complex; requires understanding the specific adjustment and its implications.

The primary source of confusion arises when a corporate action causes an existing option to become "adjusted." While new, standard options contracts for the modified underlying asset may begin trading, the old, adjusted options may continue to exist with their revised terms, creating two different sets of contracts for the same security.

FAQs

Q1: What kind of corporate actions cause options to be adjusted?

A1: Common corporate actions that lead to adjusted options include stock splits (both forward and reverse), special cash dividends, spin-offs, and changes resulting from mergers or acquisitions. The goal is always to ensure the economic value of the options contract is preserved.

⁴### Q2: Who determines how an option is adjusted?
A2: In the U.S., The Options Clearing Corporation (OCC) is responsible for determining and implementing adjustments to listed options contracts following corporate actions. They issue memos detailing the specific changes.

³### Q3: Do adjusted options trade differently from regular options?
A3: Yes, adjusted options may trade differently. They often have lower liquidity and wider bid-ask spreads because their non-standard terms (like unusual strike price or number of deliverable shares) make them less attractive to a broad range of traders. This can make them harder to buy or sell.

²### Q4: How can an investor find information about an adjusted option they hold?
A4: Investors should consult the official information memos published by The Options Clearing Corporation (OCC) on their website. Brokerage firms also typically provide details about adjustments to their clients' accounts. These memos will specify the new strike price, the number of shares per contract, and any changes to the underlying asset.

¹### Q5: Can an adjusted option revert to a standard option?
A5: No, an adjusted option does not revert to a standard option. Once adjusted, its terms remain changed until the expiration date or until it is exercised or assigned. New, standard options contracts for the modified underlying asset may be listed, but the adjusted option retains its modified terms.