Wednesday, 5 September 2012

Options In Focus: No More Splitting Headaches

If you've been involved with equity trading long enough, you're bound to have your position re-worked at some point in time due to a stock split. If you trade options this sort of thing might lend itself to a splitting headache for the uninitiated. But with some basic math we'll take you through tonight, you'll quickly realize this type of re-pricing isn't anything to be fearful of once the mechanics are learned.

Let's begin with the most common type of stock split, the 2-for-1. For shareholders this amounts to owning twice as many units of stock at half the pre-split price. As far as trading capital is concerned, the two are the same. We know this to be absolutely true by simply comparing the current market value to the old value and finding the two positions hold identical values. For instance, owning 200 shares of XYZ at 70 is the equivalent of 400 shares at 35 as simple multiplication shows a matching market value of $14,000 for each position.

With an option position, the 2-for-1 is equally easy to figure out. Similar to a stock position, the number of contracts held long or short is doubled, while the strike price and option premium are adjusted in half i.e. divided by 2. This adjustment process allows the aggregate market value or cost basis of the position to be maintained relative to the value of the position prior to the split.

In a more complex split such as a 3-for-2 or any split where "1" isn't the denominator, option traders need to approach the position differently in order to confirm the cost basis is the same as before the stock adjustment occurred. Here, we need to use a non-standard "hidden" multiplier other than the typical $1.00 per contract or $100 per contract.

The reason for this unusual step with an "odd split" is due to the potential for the new contract count to otherwise result in a non-whole number. For instance, 3 contracts prior to a 3-for-2 split would result in a position of 4.50 contracts ((3 / 2) x 3) post-split. While 450 shares are certainly allowable in one's portfolio, the equivalent 4.5 contracts is against the rules when it comes to option sizing and thus requires a multiplier to remove this predicament.

In this particular split situation the trader divides 3 ÷ 2 to come up with a non-standard (and hidden) multiplier of 1.50 or $150 per $1.00 in option premium, while the amount of contracts held, remains the same. Thus to arrive at our cost basis for the 3-for-2 split the formula: contracts held (unchanged) x new premium (old price / 1.50) x 1.50 multiplier can be used to get rid of that "splitting" headache and instead come up with the same amount of cents in our trading account as prior

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Nancy Ashley

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