what happens to options during a stock split or merger

In short

I once watched a neighbor panic over an options position when his stock company announced a split, sure that he had lost half his money overnight. He had not. If you are holding stock options, a split or a merger changes the terms of your contract, but the contract is built to keep your position fair. The Options Clearing Corporation, known as the OCC, decides how each adjustment works and posts a memo for every event. Read that memo before the event takes effect. Check your broker statement afterward, because the strike price and the share count may both look different. Ask your broker anything that seems off. It is your money, and the question is a fair one.

The whole of it

What it is

A friend of mine once said that an options contract is just a promise with a deadline. He had it about right. A listed stock option is a contract that gives its owner the right to buy or sell 100 shares of a stock at a set price, called the strike price, by a set date. When the company behind the stock changes shape, the promise has to change with it.

A stock split happens when a company cuts its shares into more pieces. A merger happens when one company joins another or is bought by another. Both events change what a share is. If the contract stayed frozen, one side would get a windfall and the other a loss. The rules exist so that neither happens.

How it works

If you have ever cut a pizza into more slices, you already know the idea behind a split. The pizza stays the same size. Only the slices change. Options work the same way, and the OCC makes the adjustment so that the total value of the contract stays about where it was.

Take the most common case first, a whole number split such as two for one. The share price drops by half after the split. To match, the OCC halves the strike price and doubles the number of contracts. The owner now holds twice as many contracts, each with a lower strike. The deliverable, meaning the shares behind each contract, stays at 100.

A split that is not a whole number, such as three for two, is handled another way. Here the strike price is cut, but the number of contracts stays the same. The deliverable grows instead. A contract that once covered 100 shares may now cover 150 shares. Options like these often get a new label, and many brokers show them with a special symbol. Do not be alarmed by it.

A reverse split goes the other way. The company combines shares into fewer, higher priced shares. The strike price rises and the contract count drops, or the deliverable shrinks, again so the value holds steady.

Mergers are more varied. If the company is bought for cash, the option usually turns into a right to receive that cash. The holder of a call gets the cash value of the deal price minus the strike, times the shares covered. If the company is bought with shares of the buyer, the contract usually turns into a right on the buyer's shares at a set ratio. If the deal mixes cash and stock, the deliverable becomes a basket of both. Each case is spelled out in the OCC memo, so no one has to guess.

The numbers, and where to find yours

I like to tell people that the numbers you need are already written down somewhere. They just have to be found. Your broker confirmation and your account statement show the new strike price, the new contract count, and the new deliverable. The OCC publishes an information memo for each corporate action, and you can search its website for the memo by company name or ticker.

The memo lists the effective date, the old and new strike, and the new deliverable. It also gives the new option symbol if one was assigned. The exchange where your option trades also posts the notice. Compare the memo to your statement line by line. If they differ, call your broker. A mismatch is rare, but it is worth a few minutes of your time. Also note that the amount of the strike changes only on the date the OCC names, so check the effective date, not the announcement date.

A worked example

Let me tell you about a woman named Ruth, a retired schoolteacher who owns 3 call option contracts on a company called Maple Tech. Each contract has a strike price of $80 and covers 100 shares. The stock trades at $90, so her calls have value.

Maple Tech announces a two for one stock split. Here is how the OCC adjusts her position, with every figure shown so Ruth can check it.

Her old strike was $80. After the split the new strike is $80 divided by 2, which is $40. Her old contract count was 3. After the split she holds 3 times 2, which is 6 contracts. Each contract still covers 100 shares.

Now check that her value held steady. Before the split, her 3 contracts covered 3 times 100, or 300 shares, at a gap of $90 minus $80, which is $10 a share. That gap times 300 shares is $3,000 of built in value. After the split, the stock trades near $45. Her 6 contracts cover 6 times 100, or 600 shares, at a gap of $45 minus $40, which is $5 a share. That gap times 600 shares is $3,000. The value matches.

Ruth had more contracts, a lower strike, and the same worth. She had lost nothing. She had only been given a different set of slices.

Now suppose a different year. A larger company called Birch Corp agrees to buy Maple Tech for $100 per share in cash. Ruth still holds her original calls with the $80 strike. When the deal closes, her calls turn into the right to receive cash. Her gain is $100 minus $80, which is $20 a share. With 3 contracts covering 300 shares, that is 300 times $20, or $6,000, before any trading fees. The memo, not a guess, tells her the exact date and method.

Where it goes wrong

Nobody likes to admit that a plain mistake can cost real money. The first trap is assuming nothing changed. An owner who sees a strange new strike may close the position in a hurry, believing the loss is real. Check the memo before acting.

The second trap is a thin market. After a nonstandard adjustment, an option may trade with few buyers and sellers. The gap between the bid and the ask can be wide, so selling can cost more than before. This is a cost, not a flaw in the contract.

The third trap is a deal that fails. If a merger is announced and later falls apart, the option rules may revert or the price may swing hard. Time left on the contract keeps running either way. An option still expires on its date.

The fourth trap is a special dividend or a spin off. These are odd events that also trigger adjustments, and the math can be less tidy. The OCC memo is again the guide. Taxes can also be involved, because a cash out in a merger may be a taxable event. The IRS explains how it treats options in its publications, and a tax professional can speak to your own case.

Questions to answer before you leave this page

Have you found the OCC memo for your company, and do you know the effective date it names? Do the strike price, contract count, and deliverable on your broker statement match that memo, line by line? If your options now cover an odd number of shares, do you understand why, and can you say it in your own words? Is the market for your adjusted option thin, and what would a wide bid and ask cost you if you needed out? How many days remain before your contract expires, and does the corporate action change that date? If a merger is pending, do you know whether your option turns into cash, shares, or both, and when? Have you asked your broker about anything that still seems off, since the question costs you nothing?