What if your options contract suddenly doubles?
You may be experiencing a stock split, where a company increases the number of available shares and reduces the cost per share to maintain the same value the trader holds in the investment. Companies typically perform stock splits when they are performing well financially and want to encourage new investment. This can be appealing to newer traders who can take advantage of a lower cost per share and buy or sell easily due to increased market liquidity.
Despite the perks that come with stock splits, some traders may be confused about the ramifications of a stock split on the options they hold during this time. This post will outline the best courses of action that traders can take with their option positions through a stock split and how the stock split can impact existing option contracts.
What Is a Stock Split? (And Why It Happens)
A stock split is when a company increases the number of available shares by dividing the existing shares into multiple new shares. For instance, there are 2-for-1 stock splits where a trader might hold one share at $50, and, following the split, the trade would have two shares at $25 each. It’s key to note that stock splits maintain the same amount of money but change the number of shares that the trader owns. Only the price per share decreases.
Reasons for Stock Splits
There are several reasons why companies choose to increase the number of shares available in the options markets, including the following:
- Affordability—The cost per share decreases with the influx of new shares created through a stock split, making the company’s shares more affordable.
- Liquidity—When the company splits its stock and creates more shares, the price per share becomes more affordable, and that makes it more appealing to smaller investors, which can lead to an overall increase in liquidity and trading volume. Stock splits result in stocks that are much easier to buy and sell quickly.
- Psychological Price Anchoring—For many traders and investors, a stock split can be a positive sign, as they perceive the company as financially healthy. This psychological price anchoring can give traders considerable confidence in the company’s future and its prospects.
Stock Split Examples
Over the past 30 years or more, Apple has executed five stock splits, all of which were 2-for-1, except for the 7-for-1 split in 2014 and the 4-for-1 split in 2020. This tracks the steady growth of the company’s early years, followed by its explosive growth in the last decade. To give you an idea of the significance of these stock splits, let’s examine the 2020 split, where Apple stock was trading at $540 per share. Following the split, Apple saw a fourfold increase in the number of shares for the company, resulting in the stock trading at $135.
Tesla is another company whose stock has undergone a couple of splits over the years, with one in 2020 on a 5-for-1 basis and another in 2022 on a 3-for-1 basis. The result of these splits is that investors have increased confidence in Tesla and its future growth prospects. Another benefit of the stock split is the increased liquidity, which makes the stock more accessible to investors with smaller capital balances.
Types of Stock Splits and Reverse Splits
What is the main difference between a stock split and a reverse stock split? Learn about what makes these two market events different from each other and what they can signify for traders or investors. There’s also something known as “uneven stock splits” that we’ll also address to give you an idea of what occurs with stock splits whose ratios don’t end with 1.
- Forward Stock Splits: As mentioned above, a forward stock split refers to the practice where a company increases the number of shares and decreases the price per share as a result. The most common format you see with forward stock splitting is the 2-for-1 or 3-for-1 format. In the case of a 3-for-1 split, the company takes an existing share and divides it into three stocks, each valued at one-third of the original share. If the original shares were trading at $39, the trader would have three shares, each valued at $13.
- Reverse Stock Splits: These are the exact opposite of forward stock splits. In this event, the company decreases the number of shares and increases the value of each share, which creates a trading environment with lower volume and reduced liquidity. It can be a sign that the company isn’t doing well financially and cannot offer its shares at lower prices. They must tighten up—the number of shares is reduced, and the cost per share goes up. A standard reverse stock split format you’ll see is a 1-for-5 deal, where the trader will own one share for every five they previously held.
- Special or Uneven Splits: These are stock splits that have ratios that don’t end with one. For example, an uneven split could appear as a 3-for-2 deal. Uneven splits adjust the strike price and the number of shares per option contract while the number of contracts remains the same. When uneven splits occur, and the result is a fractional share, the company typically provides a cash settlement to the trader.
How Stock Splits Affect Options Contracts
When a stock split occurs, the contracts are adjusted, not canceled. The adjustment is overseen by the OCC (Options Clearing Corporation) to ensure that companies are operating by the rules. New deliverables reflect the split, including factors like an adjusted strike, contract multiplier, and share count.
The contract symbol and root may stay the same, but it becomes a “non-standard” contract. These kinds of contracts differ from the standard terms of an options contract in a few ways:
- They could include a cash payment in addition to shares.
- The contract might represent less than 100 shares of the underlying asset.
- The rights associated with these non-standard contracts may include the right to receive shares in a spin-off.
Example—Forward Stock Split Adjustment
Forward stock splits are the ideal of the two possible splits because they signal that a company is doing well financially and can afford to create more shares at a lower cost, encouraging additional investment and attracting new traders they might not have had before. Let’s examine a hypothetical forward stock split, illustrating how the shares and price per share are affected.
Example: You own 1 call option for XYZ at $100 strike, and it undergoes a 2-for-1 split.
- Before split: 1 contract = 100 shares at $100
- After split: 1 contract = 200 shares at $50
Your cost basis is the same, but now you’re trading a “non-standard” option. This means you may need to reevaluate your trading strategy. Following a stock split, there is typically an influx of new traders entering the market to take advantage of the lower price per share, which can lead to increased volatility that results in a temporary price increase. A good approach to take after a stock split is to buy extra shares at a lower price and then watch the value of those shares increase immediately.
Example—Reverse Stock Split Adjustment
Please take a look at our hypothetical example of a reverse stock split adjustment, which occurs when a company decides to decrease the number of available shares and increase the price of those shares, making the trading experience less liquid and more expensive. Reverse stock splits are typically a sign of a company struggling financially, leading to decreased confidence among investors.
Example: You own 1 put option for ABC at $10, and it undergoes a 1-for-5 reverse split.
- Before: 1 contract = 100 shares at $10.
- After: 1 contract = 20 shares at $50.
Liquidity becomes a concern as non-standard options may have wider spreads. The ABC stock is going to be worth more per share, but there are now fewer shares available, which makes it much harder for traders to buy and sell the stock as quickly and efficiently as they could before the reverse split occurred.
What Traders Should Know (Actionable Tips)
Trading around stock splits involves some simple concepts that are easy to understand and implement into a trading plan. However, there are lesser-known elements about splits that can have a profound impact on your trading going forward. We’ve outlined several of these in the next section to show you some of the aspects of stock splits that you should keep an eye out for, so you aren’t caught off-guard by events you weren’t expecting.
- Check OCC Memos for Exact Contract Terms—Stock splits can affect the terms of the contract, so it’s always best for traders to review the contract terms following a split. There will be a strike price adjustment, and the number of underlying shares controlled by the contract will also be adjusted to reflect the new share count.
- Be Aware of Liquidity Drops in Adjusted Options—Stock splits can lead to decreased liquidity in adjusted options, making it harder for investors to execute these trades at higher prices. The reduced individual share price resulting from the split can impact trading activity and lead to a wider bid-ask spread.
- Consider Rolling Positions Before the Split—If liquidity is a concern, traders should consider rolling positions before the stock split occurs. This can be done to manage the adjustments that happen to options following the spoil, which can affect the strike price and the number of contracts held.
- Watch for Broker Notices and Margin Requirement Changes—The broker will adjust your account to reflect the new number of shares and the adjusted price, one of the first things to look for after a company splits its stock. Another factor to watch is the margin requirement, which may change after a split, particularly when trading volume increases, and share prices become lower and more attractive.
- Adjust Your Profit and Loss Targets and Breakeven Calculations—Because the stock split will increase the number of shares. At the same time, to decrease the price per share, traders must take the time to adjust their profit targets and stop-loss levels while also recalculating their breakeven points to obtain accurate cost basis numbers.
When Stock Splits Can Create Opportunities
The most significant advantage of stock splits is the increase in interest or volume in the underlying stock. Not only are the shares cheaper to purchase, driving interest, but they are also much easier to buy and sell quickly when needed, making them highly liquid.
Following a stock split, you’ll see plentiful opportunities to buy cheaper options because there are more contracts in the market, and they are listed for a lower price than they previously were. The result of this can be an influx of new traders entering the market, enticed by the lower prices required to buy stocks with the company. While this can lead to increased liquidity in the market, it can also increase volatility. However, it’s usually a short-term phenomenon because the stock split does not change the company’s fundamentals.
Using Stock Splits To Your Advantage
Some traders use anticipating splits as a part of their trading strategy:
- Traders will find more efficient trading following a split, with increased demand and participation from other investors, leading to higher volume and narrower bid-ask spreads.
- Stock splits make stocks more affordable to investors, offering more desirable entry points that can maximize the overall profit potential.
- Investing in a company that has undergone a stock split is a good idea for investors because it’s a sign that the company is experiencing strong performance in its industry, which will attract new investors. This can lead to increasingly better liquidity in trading this stock over time, although the cost of trading will likely increase.
- Stock splits provide an opportunity to acquire a stock at a lower price and then enjoy a slight price increase thereafter as new investors become interested in buying. Some traders can use this to experience quick gains in their investments.
Common Mistakes to Avoid
Although stock splits can be positive news for a company, traders and investors should not have any knee-jerk reactions when news of a stock split breaks. It’s essential to take the time to examine the company’s fundamentals to gain a clear understanding of its performance in the current market context.
- Assuming Options Become Worthless or Invalid—A stock split increases the number of outstanding shares while decreasing the price per share proportionately. Some traders make the mistake of believing that their options have become null and void—this isn’t the case when you’re dealing with a stock split.
- Forgetting About Adjusted Share Counts—Traders often make this mistake around the time of a stock split, which can lead to incorrect interpretations of historical data and a high likelihood of a flawed trading strategy or future decision-making. Using the adjusted data can help traders avoid false triggers and accurately pinpoint patterns and trends going forward.
- Relying on Outdated Strike Prices in Trading Platforms—Don’t make the mistake of using the outdated strike prices following a stock split. Be sure to look at the new strike prices and other updated aspects of the new shares after the split occurs to make sure you’re understanding the parameters of your new shares.
- Not Understanding Non-Standard Contract Implications—As mentioned earlier, some contracts can become non-standard, which means they may represent fewer than 100 shares of the underlying asset or include a cash payment in addition to shares. Traders must understand the implications of these non-standard contracts when they arise to trade them correctly within the appropriate parameters.
Final Thoughts on Options and Stock Splits
The best course of action a trader can take to prepare for a stock split properly is to understand the implications of the split on their current investments and to know the possible ways to take advantage of the event to trade correctly around it. If you haven’t already read through our entire guide, we encourage you to do so to gain a complete understanding of what’s possible when stock splits or reverse stock splits occur. The key to being profitable during these times is to stay informed, so learn as much as you can before you experience one yourself.
Key Takeaways on Stock Splits
- Stock splits change the structure, not the value, of your options.
- Always verify updated contract terms through your broker or the OCC.
- Be cautious with non-standard contracts due to reduced liquidity.
- Consider strategic adjustments before the split date.
Where to go from here? Check out your broker’s help section on stock splits for some additional insights on how to take advantage of or navigate stock splits. A few other helpful resources include our options trading tools and strategy guides, where you can learn more about some of the best moves to make when a company either increases or decreases its number of shares.
