Stock Split and its Effect on Option Prices

By December 26, 2015 Newsletter No Comments

A Stock Split and its Effect on Option Prices is the action a company takes that increases the number of its outstanding shares by dividing each share, which in turn diminishes its price. The stock’s market capitalization, however, remains the same. For example, if a company had 1 million outstanding shares and each shares is trading at $70 then after 2-for-1 stock split it will have 2 million outstanding shares and on the date of the split, stock will trade at $35. The market capitalization before split was $70 million (1 million shares multiply by $70), after the stock split the market capitalization will remain $70 million (2 million shares multiply by $35). The true value of the company has not changed one bit.

If an investor bought 1000 shares at $70 just the day before the stock split, then on the stock split day he will have 2000 shares. The value of his investment will remain the same which is $70,000 as on the day of the split stock will trade at $35 (after stock split the price of the stock will of course fluctuate up or down).

The most common stock splits are 2-for-1, 3-for-1, 3-for-2 and 4-for-1.

Phases of Stock Split

There are five phases of stock split:

1 – Before the Announcement

A short-term increase in stock price before the expected announcement date.

2 – Announcement

Within seconds of the announcement the stock price jumps up, and then falls back down.

3 – After the Announcement

After the announcement the stock price falls because of profit taking. Depending on the length of time between the announcement and the actual split, the stock may move and down more than once.

4 – Split Date

About three days before the split the stock price runs up. Usually the stock runs up the most just the day before the split.

5 – After the Split

Few days after the split the stock pulls back due to profit taking. It consolidates, moves sideways and then on new catalyst stock starts to move up.

Reason for Stock Split

There are various reasons for company to stock split. One reason is the psychology. As the price of a stock moves higher and higher, some investors feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more “attractive” level. Since the stock split does not effect the actual value of the stock but the lower stock price may affect the way the stock is perceived and therefore, attracts new investors.

Another reason for splitting a stock is to increase a stock’s liquidity, which increases with the stock’s number of outstanding shares. Theoretically, stock split does not have any fundamental value of the stock and therefore, no advantage to investors. However, stock split is perceived positively by investors community and is considered as a good buying indicator. One studies suggest a good solid growth company reaches its pre stock split price in few years and then it split again.

How Stock Split Effects Options

Lets take the example of CRM. On March 21st, 2013 the board of directors of CRM announced 4-for-1 stock split. CRM outstanding shares are at 400 million. After stock split its outstanding shares will be 1.6 billion. Trading of CRM on stock split basis will begin on April 18th. If on April 17th CRM closes at $170 then on April 18th it will resume its trading at $42.50. In few years down the road CRM may trade again at $170. It is this perception which is perceived as buying indicator when company announces stock split.

If you trade options then you should have a working knowledge of how stock split affects options. If the stock is splitting 2-for-1 or 4-for-1 then it is simple to understand the effect of stock split on option. For example, If you hold one contract of May 170 Calls of CRM before stock split, then after the stock split you will have four contracts of May 42.5 calls.

However, there are certain stock splits which are complicated and are done via adjustment.

The difference between a “split” and “an adjustment” depends on whether the stock can be split an integral number of times. In a 4-for-1 stock split such as the case of CRM, you will have four times as many options contracts for one-fourth the strike price.

However, if stock is splitting 3-for-2 then mathematics behind the stock split is complicated. For example, if an investor owns 100 shares and stock is trading at $60 per share before stock split then after the stock split the investor would own 150 shares (100 divided by 2 then multiply by 3) and it will trade at $40 per share.

Lets take the same example to understand the effect of stock split on options.

Lets assume you own XYZ June 60 Call. Since one call contract holds 100 shares therefore, the nominal value of June 60 Call is calculated as follows:

1 contract * $60 per share * 100 shares = $6,000.

After the split, you will hold one June 40 Call covering 150 shares of XYZ. The calculation is as follows:

1 contract * $40 per share * 150 shares = $6,000

In other words before stock split trader had one contract of 60 strike which controlled 100 shares, after stock split the trader would still hold one contract but of 40 strike and this one contract would control 150 shares.

Yahoo finance maintains stock splits calendar which can be found at the following link.

http://biz.yahoo.com/c/s.html

I hope the above information on stock split helps you in putting on the profitable trades in future.

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