How do stock splits affect options?

Mark Wolfinger provides the full scoop. 

What happens when you’re holding a long or short options position, and your underlying stock splits? How is your option affected? I came across this question from TK client Mshiwdin in a forum thread and thought it’d make an excellent post: “I had bought a $2 strike option for AIG before the stock split occurred. When I checked this morning the value is 1 cent. How will this affect my option? Does it void the option to be at $2?”

Let’s first define what a “stock split” – or in this case, a “reverse stock split” – means. Stock splits represent bookkeeping adjustments, and an investor neither makes nor loses money when such an event occurs. If the stock price rises higher when news of a stock split is announced (as it often does), then the stockholder could realize a profit afterwards.  But that profit is based on the market’s reaction to the news – it has nothing to do with the fact that the stock is splitting.

A stock split reduces the stock’s per-share price and increases the number of shares outstanding, while a reverse stock split does the opposite: increases the per-share price while decreasing the number of shares outstanding.

Here’s an example: Say stock XYZ gradually rises in price to $100, and there are 1 million shares outstanding. If a 2-for-1 stock split is declared by the company, that simply means the stock’s price will be divided by 2, to $50, and the number of outstanding shares will be multiplied by 2, to 2 million. If you compare the math pre- and post-split, you’ll notice the market capitalization (share price X # of shares) is exactly the same before and after:

$100 per share X 1 million shares = $100 million market cap
Vs.
$50 per share X 2 million shares = $100 million market cap

As the name suggests, a reverse stock split does the same thing backwards. Take company ABC with a $10 per share stock and 4 million shares outstanding. If ABC declares a reverse stock split of 1-for-2, the per-share price rises to $20 ($10 X 2), the outstanding shares (or “float”) drops to 2 million shares (4 million divided by 2), and the market capitalization remains the same.

$10 per share X 4 million shares = $40 million market cap
Vs.
$20 per share X 2 million shares = $40 million market cap

Companies declare stock splits, reverse or ordinary, for many reasons. Most companies prefer that their share price not be too high, so that more investors are willing to buy the shares. That’s the primary reason behind stock splits.

For some businesses, such as Berkshire Hathaway (BRK), the opposite may be true. At $85,000 per share – really! – BRK has fended off the roller-coaster effect of individual investors’ trading by purposefully never splitting its stock. That choice has kept the per-share price very high.  This is one stock that often does trade one share at a time.

When the share prices drops too low – usually under $1 per share -- the company may choose to declare a reverse stock split. The primary reason is to keep their shares trading on the NYSE, which delists stocks that trade below $1 for a period of time.

Now that we’ve established what a stock split is, let’s answer to Mshiwdin’s question. Let me preface this by saying that I don’t follow AIG closely, so I’m not familiar with the specific terms of whatever split may’ve occurred. My answer is based on the info Mshiwdin provided in the forum thread and can be applied to any stock / option undergoing a split, in either direction.

First, it’s important to recognize that an option is never voided. Before the corporate action (in this case, a reverse stock split), you owned the right to buy 100 shares of AIG, paying $2 per share.

Nothing has changed post-split.  You still have the right to exercise your call option, pay $200, and collect whatever it is that the owner of 100 old shares has the right to buy now. In this case the the stock underwent a 1-for-20 reverse stock split, then your call option gives you the right to pay $200 and receive 5 shares of AIG. Remember, you own the option and no one can force you to exercise that option. You may sell it (if there are any bids), or allow it to expire worthless.

Contact TradeKing to find out the specifics of any corporate actions of AIG – they’ll be happy to help you figure things out.  

Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator

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