Unscrambling Reverse Splits: What Happens to Your Options?

When a company performs a reverse stock split, the landscape of its stock ownership changes dramatically. This consolidation affects not just shareholders but also option holders. Understanding these effects is crucial for managing your portfolio effectively. In essence, after a reverse split, the number of options you hold decreases, while the strike price and the number of shares covered by each contract increase, maintaining the total contract value and proportionate exposure to the underlying stock. This adjustment aims to keep the value of your options position equivalent before and after the split.

Delving Deeper: Options and Reverse Stock Splits

A reverse stock split is when a company reduces the total number of its outstanding shares. For example, a 1-for-10 reverse split means that every 10 shares an investor owns are consolidated into 1 share. This maneuver is often employed to boost a stock’s price, usually to meet minimum listing requirements on exchanges or to improve market perception. But what happens to the options contracts tied to that stock?

The Options Clearing Corporation (OCC), which standardizes and guarantees options contracts, handles adjustments for reverse splits. The goal is to keep option holders in the same economic position they were in before the split. They achieve this by adjusting the number of contracts, the strike price, and the deliverable quantity.

• Number of Contracts: The number of option contracts an investor holds is usually reduced proportionally to the reverse split ratio.
• Strike Price: The strike price of each option contract is increased according to the reverse split ratio.
• Deliverable Quantity: This refers to the number of shares one options contract controls. In a standard equity option, one contract represents 100 shares. However, following a reverse split, the deliverable quantity will change. This is where it can become complex, as the deliverable quantity might not be in multiples of 100.

The adjustments are designed to be value-neutral. That is, the theoretical value of your options position before the reverse split should equal its theoretical value after the split. However, the new adjusted options are often referred to as being non-standard. This means the option now covers a non-standard number of shares. This can present challenges.

A Practical Example

Let’s say you own one call option contract on XYZ Corp. with a strike price of $5. The contract covers 100 shares. Then XYZ Corp. announces a 1-for-10 reverse split.

• Before the split: You have one contract covering 100 shares with a strike of $5, meaning you control the right to buy 100 shares of XYZ at $5 each.
• After the split: You still have one contract. However, the strike price will be adjusted to $50 (5 x 10). The deliverable quantity will be adjusted to reflect approximately 10 shares (100/10). The OCC will make this adjustment and clearly communicate this change with brokers. The precise adjusted contract specifications will be detailed, and these details will be available to you. It is crucial to understand them.

Navigating Non-Standard Options

The primary challenge arising from reverse splits is the creation of non-standard options. Trading these options can be less liquid and more complex. Here’s what you need to know:

• Liquidity: Non-standard options may have wider bid-ask spreads due to lower trading volume, making it potentially more difficult to execute trades at favorable prices.
• Complexity: Understanding the exact deliverable quantity is crucial when exercising or closing out your position. Consult your broker and carefully review the OCC announcements for specific details on the adjusted contract terms.
• Brokerage Support: Not all brokers fully support the trading of non-standard options. Some brokers may restrict the types of orders you can place or may have difficulty providing real-time quotes. Confirm your broker’s capabilities before the reverse split occurs.

In essence, while the OCC strives to make the adjustments value-neutral, the real-world trading of these adjusted options can introduce complexities and potentially higher transaction costs.

Strategic Considerations

Before a reverse split occurs, it’s worthwhile to consider your options (pun intended):

• Close Your Position: Depending on your outlook, closing your existing options position before the reverse split eliminates the hassle of dealing with non-standard options. This is often the simplest and most predictable solution.
• Roll Your Position: If you believe in the company’s long-term prospects, consider rolling your existing options into standard options with similar expiration dates and strike prices after the split. This may involve additional transaction costs.
• Be Patient: If your outlook is neutral, simply waiting until your option’s expiration date could be a valid strategy. The underlying stock may fluctuate, and the option’s value may evolve favorably.

Frequently Asked Questions (FAQs)

1. Does a reverse stock split always affect options?

Yes, if options exist on a stock undergoing a reverse split, those options will always be adjusted to reflect the split. The OCC will make these adjustments.

2. Who determines the adjustments to options contracts after a reverse split?

The Options Clearing Corporation (OCC) determines the adjustments to options contracts. They aim to maintain the economic equivalence of the options positions before and after the split.

3. Will I automatically receive new option contracts after a reverse split?

No. You won’t receive new contracts. Instead, your existing contracts will be adjusted to reflect the reverse split ratio. This adjustment will affect the strike price and deliverable quantity.

4. How can I find out the exact adjustments made to my options?

Your brokerage firm will notify you of the adjustments. In addition, the OCC publishes informational memos detailing the specific adjustments to all affected option contracts. These are usually available on the OCC website or through your broker.

5. Can I still trade options on a stock after a reverse split?

Yes, you can still trade options. However, be aware that the adjusted options might be less liquid and considered non-standard, potentially leading to wider bid-ask spreads.

6. What happens to my stop-loss orders on options after a reverse split?

Stop-loss orders are typically canceled automatically by your broker after a reverse split. This is because the price levels are no longer relevant due to the adjusted strike prices. You will need to re-enter your stop-loss orders based on the new, adjusted prices. Always confirm this with your brokerage, as policies can differ.

7. Are all brokers equipped to handle non-standard options trading?

No. Some brokers have limitations on trading non-standard options. Check with your broker to ensure they can accommodate the trading of adjusted options contracts. Some may restrict certain order types.

8. Is it better to sell my options before a reverse split?

This depends on your individual circumstances and outlook. If you want to avoid the complexities of non-standard options, selling before the split is a viable option. However, consider your profit/loss situation and potential tax implications.

9. How does a reverse split affect the premiums of my options?

Theoretically, the premium should adjust proportionately with the split, reflecting the adjusted strike price and deliverable quantity. However, market factors, particularly liquidity, can influence the actual premium.

10. What happens if I exercise my option after a reverse split?

If you exercise a non-standard option, you will receive (or be obligated to deliver) the adjusted number of shares specified in the contract. This might not be a round lot of 100 shares. Be prepared for the potential complexities of handling an odd lot.

11. Where can I find historical information about stock splits and their impact on options?

Financial websites like the OCC and brokerage platforms typically provide historical data on stock splits and option adjustments. Your broker can also provide assistance in accessing this information.

12. What tax implications should I be aware of when a stock I own undergoes a reverse split?

Generally, a reverse stock split itself is not a taxable event. It’s a reorganization of your existing shares. However, if you subsequently sell your adjusted shares or exercise your adjusted options, standard capital gains or losses rules will apply. Consult a tax professional for personalized advice.

By understanding the intricacies of options adjustments during a reverse stock split, you can navigate these corporate actions with confidence and make informed decisions to protect and potentially grow your investment portfolio. It always pays to do your due diligence and, when in doubt, consult with a financial advisor.