The goal of a stock split is to reduce the price per share while increasing the number of outstanding shares. Options trading, in which investors purchase and sell contracts giving them the right, but not the duty, to buy or sell an underlying asset at a defined price and time, could be significantly affected by this occurrence. Following a stock split, the options agreement is revised to reflect the new share count and per-share value. Because of this modification, the option's value will be the same before and after the stock split.

What Is An Option?

An explanation of options follows, followed by a discussion of how a stock split might influence them. An option is a contractual right granted to one party by another party to buy or sell another party's asset at a specific price and time within a specified period. A stock, index, commodity, or currency could be the underlying asset. Call options and put options are the two primary forms of options. The buyer of a call option has the right to acquire the underlying asset, whereas the purchaser of a put option has the right to liquidate the asset.

What Is A Stock Split?

A corporation will perform a stock split if it wants to divide its shares into more manageable chunks. If a firm with 100 shares decides to do a 2-for-1 stock split, the result will be 200 shares, with each shareholder receiving an additional share for every share they previously owned. As a result, the price per share would be cut in half, but more claims would be in circulation.

How Do Options Impact A Stock Split?

Following a stock split, the options agreement is revised to reflect the new share count and per-share value. Changes are made to both the number of contracts and the strike price.

Number Of Contracts

Stock splits increase the number of outstanding shares but reduce the price per share. This entails revising the options contract's contract count to account for the change in the total number of outstanding shares. If a stock split 2:1, an investor who owned one call option contract on the pre-split 100 shares would now hold two contracts on the post-split 50 shares.

Price Of A Strike

Buyers of options have the right to buy or sell the underlying asset at the strike price. The strike price is recalculated after a stock split to reflect the new per-share price. If a stock's strike price was $50 before a stock split, and that stock split 2-for-1, the latest strike price would be $25. As a result, the option's value will be unaffected by the stock split.

What Happens To Options That Are In And Out Of The Money?

Whether an option is in-the-money or out-of-the-money can affect how much value it receives from a stock split.

In-The-Money Options

The option is in-the-money if its strike price is less than the underlying asset's current market price. If a stock is selling for $70 as well as a call option is set with a $50 par value, then the option is profitable. With a lower strike price and a larger number of contracts available, an in-the-money option may become more valuable following a stock split.

Out-Of-The-Money Options

After a stock split, the strike price may go down, and more contracts will be outstanding, causing an out-of-the-money option to lose value. This decreases the likelihood of the option being exercised, making it even further out of the money. If a stock's price drops by half and a call option are purchased with an $80 strike price but then the equity is split 2 for 1, the new strike price would be $40. The option's value would be lower if the stock were $30 since it would be further out of the money after the stock split. An out-of-the-money option's value may not always decrease when a stock splits, so keep that in mind. The option's value may increase if the stock price rises sharply following the split.

Conclusion

When a stock is split, the number of shares outstanding and the per-share price must change in the options contract. Both the number of contracts and the strike price need to be changed to keep the value of the option constant before and after the stock split. A choice currently in the money may see its value rise, while an opportunity out of the funds may see its value fall. If you trade options, you must be aware of the impact that stock splits can have on your investments and make any necessary adjustments to your trading approach. Consider things and talk to a financial expert before putting your money anywhere.