Options Trading Basics includes the fact that one options contract incorporates 100 shares of the underlying security. The right or the obligation is for the purchase or sale of 100 shares of stock or exchange-traded funds. This is the rule but there are exceptions to this rule. From time to time a certain event will take place that will alter the terms of an equity options contract, making it different from the original standardized terms such as the number of deliverable shares.
Let’s first list some of the most common events that lead to contract adjustments:
- Stock splits
- Special 1-time dividends
Stock split example
- Buy 100 shares of BCI @ $205
- Sell 1 contract @ $210 strike @ $530 ($5.30 per share)
- Initial 1- month return on option = 2.6% (31% annualized)
- Upside potential (to $210 strike) = 2.4%
- Total possible 1-month return = 5%
- Stock splits 3-for-1 prior to expiration
Next let’s view a pre- and post-split comparison of this trade:
In this situation, the number of shares owned and contracts sold tripled as the strike and cost basis is cut in third. The terms of the original contract has changed but both buyers and sellers are ” made whole” with this adjustment.
Buy 100 x Ingersoll-Rand Plc (Ireland) (NYSE: IR) @$72
Sell a 1-month $72.50 call
A part of the company is spun off called Allegion (ALLE)
The price of IR drops from $72 to $55
For each share of IR owned, 1/3 share of ALLE is distributed + cash (.3333 x price of ALLE)
The original contracts of underlying IR are now recognized as having underlying IR1 where:
IR = IR1 = Current value of 100 x IR price + value of 33 shares of ALLE + .3333 x current value of ALLE
100 shares of IR1 are deliverable but you need a calculator to figure out if the contracts will be exercised
Here is a screenshot showing the explanation of the adjustment:
Next is a screen shot showing the contract adjustments with strikes staying the same but a new underlying called IR1:
To determine the likelihood of exercise the holder needs to add the value of the newly priced IR shares + 1/3 the value of ALLE + .3333 x the value of ALLE. If that total exceeds the strike of $72.50, exercise will occur. Okay, time to summarize because I’m getting a headache from all of this:
Rarely, an event, like a stock split or spin-off, will take place that will necessitate the need for option contract adjustments so that buyers and sellers are “made whole” Each situation is different so that we cannot put all changes into the same formula. When this occurs, the best track to take is to call your broker and ask for a detailed explanation. Your broker will probably not know this information initially but will have the resources to get it for you. If we know of such an event in advance (except for a split) it is generally best, not to write calls on these stocks until the event has passed and options are again standardized…it will avoid the headache I alluded to before.
Our Premium Stock Reports are getting even better: Great news for current members:
The BCI team is proud to announce the expansion of our Premium Stock Report.
Effective with the January 17, 2014 report, these releases will include the following new features as shown in the screenshot below:
- Are weekly options available?
- Is open interest for near-the-money strikes > 100 contracts?
- Ex-dividend dates will be shown in the “comments” column, if applicable
Over the years, our team has always responded to the requests and suggestions by our members and these new additions have been the most frequently recommended recently.
Good news about premium member rates:
Although the additional time and manpower required to add these features will result in a member fee increase there is good news for all current premium members and those who plan to subscribe prior to January 17th.
All current premium members and those who join prior to January 17th, 2014 will be grandfathered in at the current membership rates so you will see no fee increase.
Those who join after January 17th will see a modest increase for trial membership to $14.95 for the first month and then $39.95 thereafter. Annual memberships will also see an increase based on the new monthly rates. Current premium members (both monthly and annual) need to take no action as the upgraded reports will be available at no additional expense. We encourage those who plan to join to do so prior to January 17th.
***Beta-testing for the new format will begin with the report dated 12-13-2013 so all premium members will see the new format and additional information with the current reports.
Thanks for your continued support.
I am shocked! The House of Representatives actually passed a bipartisan compromise looking to avoid another government shutdown. The vote was 332 – 94…about time. Now the pessimists are asking if this might be the launching pad for a scaling back of the economic stimulus program. As I wrote in last week’s blog, this, too, is my concern…not so much the scaling back but the market’s reaction to it. That’s why this site has maintained its bullish economic outlook but is taking a more cautious approach to short-term investments while this issue clarifies itself. All eyes will be on the FOMC meeting which begins this Wednesday. This week’s reports:
- The Labor Department reported that the producer price Index (PPI) declined for the 3rd month in a row (by 0.1%). Depressed inflation may have a negative impact on the economy. Declining energy prices was a major factor
- Core inflation (excluding food and energy) was @ 0.1% as analysts anticipated
- Retail sales rose a surprising 0.7% in November, more than double the rate expected
- October sales growth was revised upward from 0.4% to 0.6%. With the budget deal in place consumer confidence may continue to support spending, a positive for our economy
- According to the Commerce Department, business inventories (a report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) rose by 0.7% in October, more than doubling expectations
For the week, the S&P 500 declined by 1.6%, for a year-to-date return of 27%, including dividends.
IBD: Uptrend under pressure
BCI: Moderately bullish but taking a cautious approach by selling an equal amount of in-the-money and out-of–the-money strikes.
Wishing you a wonderful holiday season.
Alan and the BCI team ([email protected])