Option adjustment

What Is Option Adjustment?

Option adjustment refers to the process by which the terms of existing options contracts are modified in response to certain events affecting the underlying asset. This falls under the broader category of Financial Markets and Derivatives trading. These adjustments are critical to ensure that the economic value of the option contract is preserved for both holders and writers following significant changes to the shares or other financial instruments upon which the option is based. The primary authority for determining and implementing option adjustments in the U.S. market is the Options Clearing Corporation (OCC), which ensures consistency and fairness across exchanges¹⁶. Without proper option adjustment, a corporate action could unfairly benefit one side of the contract at the expense of the other.

History and Origin

The need for option adjustment became evident with the growth of standardized options trading. As options contracts gained popularity, particularly after the establishment of the Chicago Board Options Exchange (CBOE) in 1973, it became necessary to establish clear rules for how contracts would be treated when the underlying securities underwent changes. Corporate actions such as stock splits, dividends, mergers and acquisitions, or spin-offs directly impact the shares that an option contract represents. The Options Clearing Corporation (OCC), as the central clearinghouse for options in the U.S., developed and refined its rules and interpretative guidance over time to address these scenarios¹⁵. Their role is to ensure that the aggregate intrinsic value of the option is maintained before and after the corporate event¹⁴. The Securities and Exchange Commission (SEC) also plays a role in overseeing the regulatory framework for derivatives use by registered investment companies, including mutual funds and exchange-traded funds, to ensure investor protection¹³.

Key Takeaways

• Option adjustment alters the terms of existing option contracts to account for corporate actions affecting the underlying security.
• The Options Clearing Corporation (OCC) is the primary authority responsible for determining and implementing these adjustments to maintain contract fairness.
• Adjustments can affect the strike price, contract multiplier, or the type and quantity of deliverables.
• Common events triggering adjustments include stock splits, reverse stock splits, special dividends, mergers, and spin-offs.
• The goal of an option adjustment is generally to preserve the economic value of the contract for both option holders and writers.

Interpreting the Option Adjustment

Interpreting an option adjustment requires understanding how the contract's fundamental terms—the strike price, the number of shares per contract (multiplier), and sometimes the actual deliverable—have changed. An option adjustment aims to preserve the total value of the option position, so that an investor's profit or loss potential from exercising the option remains consistent, assuming no change in the underlying's intrinsic value. For instance, if a company undergoes a two-for-one stock split, an option contract representing 100 shares at a $50 strike price might adjust to represent 200 shares at a $25 strike price. This keeps the total exercisable value (100 shares * $50 = $5,000 vs. 200 shares * $25 = $5,000) the same. Traders must consult official OCC information memos, often available through their brokers or directly on the OCC website, to understand the precise terms of any adjustment. This is crucial for managing their positions and calculating the potential market value of their adjusted options.

Hypothetical Example

Consider an investor who holds a call option on XYZ Company stock with a strike price of $100 and an expiration date several months away. Each options contract typically represents 100 shares of the underlying asset.

Suppose XYZ Company announces a 1-for-2 reverse stock split, meaning that for every two shares held, shareholders will now own one share. To maintain the economic value of the options, an option adjustment would occur:

1. Original Contract: 1 contract, 100 shares, $100 strike price. Total value to acquire shares: $100 * 100 = $10,000.
2. Adjustment: The OCC would adjust the contract to reflect the reverse split. The number of shares per contract would likely be halved, and the strike price doubled.
   • New shares per contract: 100 / 2 = 50 shares
   • New strike price: $100 * 2 = $200
3. Adjusted Contract: 1 contract, 50 shares, $200 strike price. Total value to acquire shares: $200 * 50 = $10,000.

In this scenario, the total dollar amount required to exercise the contract remains the same, preserving the investor's original economic exposure, albeit with fewer shares at a higher strike price per share.

Practical Applications

Option adjustments are a vital component of the derivatives market, ensuring fairness and continuity in options trading. They are primarily applied when a company undertakes a corporate action that materially impacts its share structure or value. This includes events such as:

• Stock Splits and Reverse Splits: To reflect changes in the number of outstanding shares and share price, the contract multiplier and strike price are typically adjusted.
• ¹² Special Cash Dividends: Unlike ordinary cash dividends, which are typically priced into options premiums and do not usually trigger adjustments, large, unexpected special dividends often lead to adjustments to prevent immediate arbitrage opportunities. Th¹¹e adjustment might involve a reduction in the strike price or a change in the deliverable to include a cash component.
• ¹⁰ Mergers, Acquisitions, and Spin-offs: When a company is acquired, merges, or spins off a new entity, the underlying security of an option contract may cease to exist or change substantially. In these cases, the option may be adjusted to deliver shares of the new entity, a combination of cash and new shares, or be converted to a cash-settled contract.

T⁹he Options Clearing Corporation (OCC) standardizes these option adjustment processes across exchanges, providing detailed information memos for each event. Th⁸is transparency is crucial for market participants, including institutional investors and individual traders, to accurately price and manage their options contracts and related risk management strategies.

Limitations and Criticisms

While option adjustment is designed to maintain fairness and economic equivalence, the process is not without its limitations and complexities. One criticism centers on the potential for ambiguity or a lack of standardization in how certain corporate actions are treated. Although the Options Clearing Corporation (OCC) strives for uniformity, some events, particularly unusual dividends or complex reorganizations, can lead to case-by-case determinations that may not always align with market expectations. Th⁷is can introduce uncertainty and affect trading volume and liquidity for adjusted options.

Furthermore, adjusted options, sometimes referred to as "non-standard" or "packaged" options, can trade with lower liquidity and wider bid-ask spreads compared to standard options. This can make it more challenging for investors to exit their positions at favorable prices, especially if the option is now in-the-money or has a non-standard deliverable. Fo⁶r example, an option adjusted to deliver fractional shares or a combination of cash and shares might be harder to value and trade. While the intent is to preserve economic value, the practical implications for retail investors holding these adjusted contracts can involve increased transaction costs or difficulty in unwinding positions. Investors are generally advised to stay informed about potential corporate actions and their likely impact on their option positions.

Option Adjustment vs. Corporate Action

The terms "option adjustment" and "corporate actions" are closely related but refer to different concepts. A corporate action is a decision or event initiated by a company's board of directors or management that directly impacts the company's securities and/or capital structure. Examples include stock splits, dividends, mergers and acquisitions, or spin-offs. These events inherently change the underlying asset upon which an option is based.

A⁵n option adjustment, on the other hand, is the consequence of a corporate action as it pertains to outstanding options contracts. It is the mechanism by which the terms of an option (like its strike price, contract multiplier, or deliverable) are altered by the Options Clearing Corporation (OCC) to ensure that the economic value of the contract is preserved despite the changes to the underlying security. Th⁴erefore, a corporate action is the trigger, and an option adjustment is the necessary response to maintain fairness in the derivatives market.

FAQs

Q: Why are options adjusted?
A: Options contracts are adjusted to ensure that their economic value is preserved when the underlying asset undergoes significant changes due to corporate actions, such as stock splits, mergers, or special dividends. Without adjustment, one party to the contract would unfairly benefit at the expense of the other.

Q: Who decides on option adjustments?
A: In the United States, the Options Clearing Corporation (OCC) is the authority responsible for determining and implementing option adjustments. They issue information memos detailing the specific changes for each affected option series.

³Q: Do all dividends cause an option adjustment?
A: No, generally, only "special" or "non-ordinary" cash dividends typically trigger an option adjustment. Regular, recurring cash dividends are usually anticipated and are already factored into an option's premium, so they do not typically lead to an adjustment.

²Q: What parts of an option contract can be adjusted?
A: An option adjustment can modify the strike price, the number of shares represented by one contract (the contract multiplier), or the underlying deliverable itself, which might become a combination of cash and/or shares of a new entity.

¹Q: What should I do if my option contract is adjusted?
A: If your options contracts are adjusted, you should review the official information memo from the Options Clearing Corporation (OCC) or consult your brokerage firm for details. Understanding the new terms, including the adjusted strike price and deliverable, is crucial for managing your position and understanding its current market value.