What Happens to Call Options When a Stock Splits?

When a company’s stock undergoes a split, the terms of associated call options are adjusted to reflect the change in the underlying shares. A call option grants its holder the right, but not the obligation, to purchase a specific number of shares of a stock at a predetermined price, known as the strike price, before a certain expiration date. A stock split is a corporate action that alters the number of a company’s outstanding shares, impacting its share price proportionately. These adjustments ensure the original economic value of the option contract is maintained for the investor.

Understanding Stock Splits and Call Options

A stock split occurs when a company increases its number of outstanding shares by dividing existing shares into multiple new shares. For instance, in a 2-for-1 stock split, a shareholder owning one share would then own two shares, with the price of each new share being half of the original. Companies often execute stock splits to make their shares more accessible to a broader range of investors by lowering the per-share price, which can enhance trading liquidity. The total market capitalization of the company remains unchanged after a stock split, as the increase in share count is offset by a proportional decrease in share price.

A call option represents a financial contract that gives the buyer the ability to purchase an underlying asset at a specified price, called the strike price, on or before a particular expiration date. Options contracts represent 100 shares of the underlying stock. The strike price is the price at which the underlying stock can be bought, and the expiration date marks the final day the option can be exercised. These components, alongside the underlying stock’s market price, determine the option’s value and potential profitability.

Adjustments to Call Option Contracts

When a stock undergoes a split, call option contracts are adjusted to ensure the option holder’s intrinsic value remains unchanged. The Options Clearing Corporation (OCC) automatically manages these adjustments by modifying the option’s strike price and the number of shares each contract represents.

For a standard forward stock split, the strike price is divided by the split ratio, and the number of shares per contract is multiplied by the same ratio. For example, consider an investor holding one call option contract with a strike price of $100 on a stock trading at $110, representing 100 shares. If the company announces a 2-for-1 stock split, the option contract will be adjusted. The new strike price becomes $50 ($100 divided by 2), and the contract will now represent 200 shares (100 shares multiplied by 2).

This adjustment ensures the total value deliverable upon exercise remains consistent. Before the split, exercising the option would cost $10,000 (100 shares x $100 strike price). After the 2-for-1 split, exercising the adjusted option still costs $10,000 (200 shares x $50 strike price). This preserves the economic terms of the original contract for the option holder.

Similarly, for a 3-for-1 stock split, an option contract for 100 shares at a $90 strike price would adjust to control 300 shares at a $30 strike price. For non-integral splits, such as a 3-for-2 split, the number of shares per contract adjusts proportionally. An option initially representing 100 shares would convert to represent 150 shares (100 shares multiplied by 3/2), and the strike price would be divided by 1.5. For instance, a $60 strike price would become $40 ($60 divided by 1.5).

Forward Splits and Reverse Splits

The method of adjusting call option contracts varies depending on whether the stock undergoes a forward split or a reverse split. A forward stock split increases the number of shares and proportionally decreases the share price. This results in a lower strike price and a higher number of shares represented by each option contract, making the stock more affordable and liquid.

Conversely, a reverse stock split consolidates existing shares into a smaller number of shares, proportionally increasing the share price. For example, a 1-for-10 reverse split means that for every ten shares an investor previously held, they now own one share, with each new share being worth ten times the original. When a reverse split occurs, the terms of existing call option contracts are adjusted in the opposite direction of a forward split. The strike price is multiplied by the reverse split ratio, and the number of shares per contract is divided by that same ratio.

Consider a call option controlling 100 shares at a $20 strike price before a 1-for-5 reverse split. After the adjustment, the contract would represent 20 shares (100 divided by 5), and the strike price would increase to $100 ($20 multiplied by 5). This ensures the total value of the underlying shares controlled by the option remains equivalent.

Impact on Option Value and Trading

While the adjustments to call option contracts ensure that the intrinsic value of the option position is preserved, the market premium or extrinsic value of the option can still experience fluctuations. The intrinsic value, which is the difference between the stock price and the strike price for in-the-money options, remains mathematically equivalent. However, the option’s premium, which includes time value and implied volatility, can be influenced by changes in market sentiment, perceived liquidity, and investor behavior following a split.

The liquidity of option series may temporarily be affected immediately after a stock split, especially for less actively traded options. Traders and market makers adjust to the new contract specifications, and trading volumes may take some time to normalize. The Options Clearing Corporation (OCC) standardizes and manages these adjustments across the options market, providing clear guidelines on how contracts are modified.

After the adjustment, option contracts trade with their new specifications, including the revised strike price and number of shares. The adjustments are handled automatically by the clearing house and reflected in brokerage accounts, allowing option holders to continue managing their positions based on the adjusted terms.