Corporate Actions and Non-Standard Options

Corporate actions can alter both the structure and the price of a company's outstanding shares. Such actions include stock splits, reverse stock splits, spinoffs, mergers, and dividends. Each of these actions has distinct effects, but all will result in changes to your stock positions if you hold them. Since each situation varies, it's advisable to consult with the OCC to understand how a specific corporate action, like a stock split, will impact your option contracts.

Stock split

In a stock split (also called a forward split), a company splits up its shares into smaller shares. For instance, if you’re holding 10 shares of ABC worth $10 each ($100 total), and ABC splits its stock at a rate of 10:1, you will have 100 shares of ABC worth $1 each after the split.

Reverse stock split

A reverse stock split, as the name suggests, is the opposite kind of action. In a reverse split, a company consolidates the number of shares outstanding, and the stock price increases by that same ratio. For example, if you hold 100 shares of ABC at $1 each ($100 total), and ABC reverse-splits its stock at a rate of 10:1, you will have 10 shares of ABC worth $10 each after the reverse split.

Spinoff

A spinoff occurs when a new, independent company is created from part of an existing company. Typically, new shares are issued during a spinoff that represent equity in the newly formed company, and often, some of these shares will be distributed to holders of the original company’s stock. For instance, ABC might decide to spin off one of its divisions under the name “XYZ incorporated.” Much like in the previous examples, the company would decide on a distribution ratio for the new shares. For example, let’s use a ratio of 0.05, or 5%. At this ratio, someone holding 100 shares of ABC would keep all 100 ABC shares and receive 5 shares of XYZ automatically when the spinoff takes effect.

Merger

Mergers occur when two companies combine into one larger company, or when one company buys another one (also called an acquisition). In either case, the shares of at least one existing company cease to exist. Mergers and acquisitions can be complicated, but we’ll stick with some simple examples to illustrate the concept:

If ABC acquires PQR, PQR will cease to exist as an independent entity, its shares will be delisted, and it will no longer trade. In some cases, ABC might choose to issue shares of its own stock instead, at a previously decided distribution ratio. Just like with spinoffs, a ratio of 0.05 or 5% would result in 5 shares of ABC being issued for every 100 shares of PQR. But unlike with a spinoff, you wouldn’t keep the original shares.

In other cases, the acquiring company may simply buy out the existing shares for cash. If ABC and PQR agreed on a merger or acquisition deal with a buyout at $6 per share, instead of receiving stock, you would receive $600 cash for your 100 shares of PQR.

Dividends

Perhaps the most common kind of corporate action is a dividend. Many companies issue them on a regular basis. A dividend usually takes the form of a simple cash payment, which lowers the stock price by the same amount. For example, if you’re holding 10 shares of ABC, and it’s trading at $10 per share, your ABC position is worth $100. If ABC then issues a $1 per share dividend, the stock price will go down to $9 per share, your position will be worth $90, and you’ll receive the dividend as a $10 cash payment.

In some cases, a company may decide to issue a stock dividend, in which additional shares of stock are issued instead of cash. This can take the form of common or preferred shares. Apart from the difference in the asset issued, a common share dividend behaves like a standard cash dividend, in that it often dilutes the value of the existing shares. A preferred share dividend behaves similarly to a spinoff, resulting in a second set of shares issued to holders of the original stock.

Uneven splits

So far, we’ve looked at simple examples, with round numbers that are easy to calculate. But what if instead of 10:1, a stock was to split at a ratio of 3:2, or 5:4? Or what if instead of 100 shares, your existing position was 73 shares? These look a bit tricky, but the math is still quite simple.

In the case of a 3:2 forward split, you would receive three shares for every two shares you already hold. Your position of 100 ABC shares would be multiplied by 3/2, resulting in a position of 150 shares. The value of each individual share would decrease proportionally, being multiplied by 2/3. This means that if the pre-split price of ABC was $10, that price would go down to $6.67 after the split.

In the case of a 10:1 reverse split, if your position does not divide cleanly into 10, you may receive a cash-in-lieu payment for the remainder. For instance, if you have 73 ABC shares worth $1 a share, and ABC undergoes a reverse split at 10:1, the result would be 7 shares of ABC worth $10 each, and a $3 cash-in-lieu payment for the remaining 3 shares.

Change in price vs. change in value

Corporate actions will usually have a direct effect on the price of the stock in question, but they do not necessarily change its value. In splits and reverse splits, the share price times the number of shares in your position will give you the same total amount after the split as before. Likewise, in a cash or stock dividend, the amount of the dividend issued should equal the reduction in the price of the existing shares. That said, corporate actions will typically have an impact of some kind on the market attitudes of investors.

What happens to my options?

Option contracts can be held on long time horizons. You can hold an option position with weeks, months, or even years to expiration, so there are usually a lot of option contracts trading when their underlying symbol goes through a corporate action. What happens to the terms of these contracts when the structure of the underlying asset is changed? Often, but not always, the result is a corresponding adjustment in the terms of the contract, which results in what we call a "non-standard option".

In option terminology, an option contract is considered "standard" when its deliverable (the asset being traded) is 100 shares of one underlying stock. If the deliverable is an amount of shares other than 100, or if additional deliverables are added, such as cash or shares of another stock, the option is "non-standard". To learn more about non-standard options, please see below.

Non-standard options

Non-standard options arise when an option contract undergoes adjustments due to corporate actions such as stock splits, reverse splits, spinoffs, or mergers. These adjustments alter the original terms of the option, such as the deliverable (the asset being traded) or the strike price. Non-standard options are typically denoted differently in the options chain (e.g., “ABC1” instead of “ABC”). An example:

Stock ABC undergoes a 20-for-1 reverse stock split, a standard option contract representing 100 shares would be adjusted to represent 5 shares.

The adjusted option may now be labeled “ABC1” and would be denoted as “20 Jan 2023 5/100 ABC1,” indicating the new deliverable of 5 shares. The “5/100” denotes the adjusted deliverable, and the ABC1 denotes that the option is nonstandard. If the stock has gone through multiple actions that resulted in multiple nonstandard option adjustments, you could see ABC2 options, or even ABC3, etc.

There are many ways for an option to become non-standard. In the example we just looked at, the action in question was a simple reverse split with a round number that divides evenly into 100. But as we discussed earlier, not every corporate action is so simple.

If ABC’s reverse split ratio was 12-to-1 instead of 20, the original 100 shares could not be divided evenly. In this case, instead of dividing 100 by 12 and adjusting the deliverable to 8.3334 shares, the following adjustment might be made instead. 96 of the underlying shares could be consolidated into a deliverable of 8 post-split shares, and the remaining 4 shares could be replaced with an equivalent amount of cash.

In this case, that cash would be added to our new non-standard option as a second deliverable. This means that buyers of that call option would be entitled to the new shares AND the cash if they decided to exercise it, and sellers of that option would be responsible to sell the shares AND pay that amount of cash if their short call is assigned.

A similar process can occur with spinoffs and preferred-share dividends. If ABC spins off its XYZ division, or creates a class of preferred stock named XYZ, and issues 5 shares of XYZ per 100 shares of ABC, those 5 shares might become the second deliverable on an ABC1 nonstandard option. In that case, a call buyer exercising the option would have the right to buy 100 ABC shares and an additional 5 XYZ shares per contract. Additionally, a seller of the ABC1 covered call would be obligated to sell the 100 ABC shares and the 5 XYZ shares, and would need all 105 shares in their account for the call to remain covered.

The deliverable isn’t the only thing that can change when an options contract undergoes a non-standard adjustment. In some cases, the strike price of the option can be adjusted instead, or alongside it. These adjustments will be made using a “strike divisor.” The strike divisor is the factor by which an established strike price will be reduced when the option is converted from standard to non-standard.

An adjustment resulting from a 20-to-1 split might use 20 as the strike divisor. In that case, the new option could still provide the standard 100 share deliverable, but those 100 shares would only represent 1/20th of the pre-split shares. If the established strike price of the original option was $80, dividing that price by a strike divisor of 20 would give us a new strike price of $4.

An important thing to note here is that if either the deliverable or the strike price is adjusted by our split-factor of 20, then the terms of the nonstandard option accurately reflect the adjustment. In these cases, the ratio of the new deliverable to the original strike price (or the ratio of the new strike price to the original deliverable) remains at 20-to-1. All that changes is which element is the 20 and which element is the 1. But if both were adjusted by 20, the ratio of the deliverable to the strike price would remain at 1-to-1, and the split would not be reflected. In the rare cases where both the deliverable and the strike price are adjusted, it is typically due to more complicated math.

With possible adjustments to the deliverable, and the strike price, adjustments up or down, and even or uneven adjustments, there are too many different possible scenarios to describe them all in detail, but the goal of the adjustment is always the same: to keep the terms of the nonstandard options proportional to the standard terms under which they were issued.

In every case, the Options Clearing Corporation (OCC) will issue a public memo detailing the terms of any non-standard adjustment, which can be viewed for free through the OCC's website.

Risks of Non-Standard Options

Liquidity risk

Non-standard options often suffer from lower trading volumes compared to standard options, making it harder to exit positions quickly or at favorable prices. This lack of liquidity can increase the risk of loss.

Complexity and confusion

Adjusted terms may not be immediately obvious in the options chain. For example, a trader might misinterpret the terms of a non-standard option, leading to significant losses if the contract is exercised without understanding the adjusted strike price and deliverable.

Due diligence

Always review the specific terms of any non-standard option before trading. The Options Clearing Corporation (OCC) issues detailed memos on these adjustments, which are publicly available and provide essential information about the modified terms.

Non-standard options, while valid investment instruments, require careful management due to their unique risks. Traders must ensure they fully understand the adjusted terms before engaging in any transactions involving non-standard options. Always consult the OCC’s public memos and verify the details to avoid unexpected outcomes.

Option trading entails significant risk and is not appropriate for all investors. Option investors can rapidly lose the entire value of their investment in a short period of time and incur permanent loss by expiration date. You need to complete an options trading application and get approval on eligible accounts. Please read the Characteristics and Risks of Standardized Options and Option Spread Risk Disclosure before trading options.