Call options give you the right to buy a stock at a certain share price. If the stock splits and the share price drops, that could be detrimental to the value of your option contracts. To adjust for the effects of the stock split, your options position will also be changed.
Stock Split Effects
A stock split increases the number of a company's shares and at the same time reduces the share price. A split is declared with the number of new shares to replace the current outstanding shares. Typical split ratios include 2 for 1, 3 for 1, 3 for 2 and 5 for 2. An investor who owned 100 shares of a $50 stock would own 200 shares of a $25 stock after a 2-for-1 split.
Whole Splits and Options
A whole number stock split ratio will result in a proportional increase in call options and a proportional decrease in the option strike price. Whole splits have a "1" in the second part of the ratio, such as 2 for 1, 3 for 1 or 5 for 1. For example, if you own two $50 strike price calls on a stock that declares a 5-for-1 stock split, after the split you would own 10 call options with a $10 strike price.
Fractional Stock Splits
Call option adjustments are handled differently for uneven stocks splits such as 3 for 2 or 5 for 2. A trader cannot hold a fractional option contract which would be the result if one contract was adjusted in a 3-for-2 ratio. With this type of split, the number of shares a call option covers is increased from the standard 100 shares by the split ratio. For example, one call option with a $60 strike price would be for 150 shares with a $40 strike price after a 3-for-2 split.
Effects of Splits on Option Values
The purpose of adjusting option contracts when a stock splits is to keep the value of the options in line with the number of shares and new share price after the split takes effect. The biggest change if you are holding call options would be the potential for higher commissions if you sell a larger number of contracts. Also, since the share price drops due to a split, a $1 change in the value of the underlying stock will have a larger proportional change on the value of the call options.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.