Wednesday, September 17th, 2014

Options in a Stock Split

 

What happens when you have purchased calls on XYZ Company and their stock splits? Options in a stock split also split, so to speak. Many traders believe that the resulting bump in stock price that occurs with a split is beneficial to those who have purchased call options or sold put options. Here are a few thoughts about options in a stock split.

Stock Splits

What a company decides to split its stock two for one it immediately has twice as many shares but the same market capitalization. So a $50 share becomes two $25 shares, for example. Two for one, three for one and three for two splits are the most common but a company may choose to split their stock any what that they choose. A common reason for splitting stock is in order to keep the value of a share within a given price range. A common experience is that investors are less inclined to purchase a stock when the share price has gone up, even when the stock has a low price to earnings ratio and excellent intrinsic value. When the stock is split two for one investors may step back in and start buying again even through fundamentals have not changed. That is to say a stock split may result in a mini rally. But what happens to options in a stock split?

Options in a Stock Split

There are three aspects to consider regarding options in a stock split.

  • A split results in the exact same profit or loss in options trading, provided that the perceived value of the stock does not change
  • A split often results in a boost in share price resulting in profits for those who have purchased calls and added protection for those who have sold puts
  • A lower share price as a result of a stock split will commonly increase trading volume which can be useful for those using technical analysis of options as a trading approach

If you buy calls to lock in opportunity on a promising stock your options in a stock split may benefit from the split. In the best case scenario the split encourages investors to buy more of the stock and in turn drive up the price. Likewise your technical indicators of market sentiment may be more accurate as statistical prediction benefits from greater numbers.

The Mechanics of Stock Prices and Options in a Stock Split

When a stock splits the records of stock price on stock charts is rewritten to assume that the stock did not split. For example, our XYZ stock was $50 and now is $25. The stock chart does not show the stock falling from $50 to $25. Rather it is rewritten for the new number of shares in the company so that the share price of the previous day is adjusted backwards for the split. A company such as Microsoft went through many splits over the years. Its share price would be in the thousands of dollars today. But it has been repeatedly adjusted for split and sits in the $30 range today instead of the $60,000 range. The effect for Microsoft has been to maintain liquidity as its share price has risen. Profitable options strategies regarding options in a stock split may well be to buy calls at the mention of a split in anticipation of a bump up in stock price and increased trading volume. In all cases do your own homework and technical analysis.

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