Stock options are worth something only if the price at which they allow you to buy shares is lower than what it would cost you to buy shares on the open market. Stock splits, meanwhile, have the effect of lowering the stock's market price. To keep splits from wiping out the value of stock options, the contracts that provide options get adjusted automatically when a split takes place.
Options and Splits
A stock option is simply a contract that gives you the right to buy a certain number of shares of stock at a specific price -- the "strike price" -- within a certain time frame. The contract spells out all the specifics; a standard option contract covers 100 shares. A stock split, meanwhile, is a maneuver in which a company increases the number of shares it has outstanding -- that is, available for trading -- while reducing the share price a proportionate amount. In a 2-for-1 split, for example, a company that starts out with one million shares outstanding worth $30 apiece will end up with two million shares worth $15 apiece. The company's market capitalization is the same before and after: $30 million.
Say you hold an option to purchase 100 shares of a company's stock at $20 apiece, and the stock is currently trading at $30 a share. Your option is said to be "in the money," because the strike price is lower than the market price. Now say the company splits its stock 2-for-1, so that each share is worth only $15. At first glance, it looks like your option will be out of the money. But that won't really be the case, because when the stock splits, your option contract adjusts.
The Options Clearing Corp., the organization that guarantees options and futures contracts, automatically adjusts stock options so that the contract holder's position doesn't change. Again, say you hold an option for 100 shares at $20 a share, and the stock is trading at $30. When the stock splits 2-for-1, your contract will be adjusted so that you'll have options for 200 shares at $10 a share. Your position hasn't changed. Previously, you had an option for 100 shares, each of which was in the money by $10. Now you have options for 200 shares, each of them in the money by $5. In both cases, the difference between the strike price of your options and the market price of the shares totals $1,000.
Companies don't always carry out neat 2-for-1 or 3-for-1 splits. Sometimes it's something like 5-for-4 or 3-for-2. In those cases, you could wind up with a non-standard contract for something other than 100 shares. You might go from having, say, options for 100 shares at $20 apiece to having options for 125 shares at $16, or for 150 shares at $13.33. However, the same principle holds: The value of your options relative to the market price of the stock won't change.
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