Options Trading and the Effect of Stock Splits: What You Need to Know

INTRODUCTION

Options trading is a popular investment strategy that allows traders to speculate on the future movement of stock prices without actually owning the underlying shares. On the other hand, stock splits are corporate actions that involve dividing existing shares into multiple shares, thereby lowering the price per share. In this article, we will explore the basics of options trading, understand the concept of stock splits, and analyze the impact of stock splits on options trading. 

Options are financial derivatives that give traders the right, but not the obligation, to buy (call options) or (put options) a specific quantity of an underlying asset (such as stocks) at a predetermined price (strike price) within a specified timeframe. Options trading offers various strategies, including buying calls or puts, selling covered calls, and utilizing spreads and combinations. It provides flexibility and potential profit opportunities, but it also carries risks such as the potential loss of the premium paid.

What is a Stock Split 

A stock split is a type of corporate action taken by the company to increase the number of outstanding shares in the open market. Usually, it is done when the price of a share is constantly increased because of constant buying. This makes it difficult for retail investors to buy the stock at a spiked price. So, the company decided to break the stock price into splits, making it easy for everyone to buy. For the ones who have already purchased the share, the number of shares in the portfolio increases based on the company’s decisions. The main motto is to attract new investments, which eventually increases the market cap of the company too. 

Stock Split Calculation

Every company decides on a different ratio to issue the stock split. But here’s how the mechanism works; supposed the stock is trading at a good price of Rs1000 and the company decides to split it in a ratio of 1:2 to attract more investors. In this case, the stock will now trade at Rs500. But, the previous shareholders will have double the number of shares in their portfolio. Their investment amount remains the same, just the number of shares in it increases. Simply, in this case, for every share you own, you’ll receive one more. Additionally, if the split happens in a 1:3 ratio then, the previous shareholders receive 2 extra shares for every share. 

Is a split good for a stock?

A stock split happens for various reasons that include, increased liquidity, wider stockholder base, future growth perception or simply to attract new investments. Seeing it from the practical view, the price of stock increases due to increased demand. This clearly states that investors are showing good interest in the stock, and anticipating good growth. If in the increased demand, the stock also becomes accessible to all retail investors, it can be taken as a positive sign. 

Stock Split vs Reverse Split 

A stock split and a reverse stock split are corporate actions that change the number of outstanding shares while ensuring that a company’s market capitalization remains intact. 

A stock split occurs when a corporation divides its existing shares into numerous shares, resulting in a discounted price per share. In a 2-for-1 split, for example, shareholders receive two shares for every one they previously held, resulting in the share price getting reduced to half. This is often done to boost liquidity and to attract additional investors. 

In contrast, a reverse stock split merges shares, reducing their number while correspondingly increasing the share price. For example, in a 1-for-5 reverse split, stockholders receive one share for each five they held, essentially increasing the value of the share. Companies may use reverse splits to prevent delisting from stock exchanges due to poor share prices, thus broadening their appeal to institutional investors.

Both splits are done to manage the market conditions, but a stock split can be seen as a positive signal for investment. Whereas, reverse stock split cannot be. 

KEY CONSIDERATIONS IN OPTIONS TRADING

Options traders should pay attention to stock split announcements, as they can significantly impact options positions. It is essential to evaluate the adjustments made to strike prices, contract sizes, and premiums. Additionally, traders need to monitor the liquidity and trading volume of options contracts after a stock split. Adjusting strategies and risk management techniques accordingly can help navigate the changing landscape.

Below are given some points to consider:-

1. OPTIONS GREEK:

The Greeks are important factors that affect how options contracts are priced and behave. Option Greeks are made up of three components:-

DELTA: Delta is a measure of the change in an option’s price or premium resulting from a change in direction of the underlying asset.

THETA: Theta measures the rate at which the option loses its time value as the expiration date draws near.

VEGA: Vega is the Greek that measures an option’s sensitivity to implied volatility.

2. MONEYNESS:

This concept include three terms explained below:-

IN THE MONEY ( ITM ): For call options strikes lower than the underlying price and having some intrinsic value are called ITM(in the money) and vice versa in put options.

AT THE MONEY ( ATM ): Strikes closest to the current market price of underlying with a negligible intrinsic value are called ATM(at the money).

IN THE MONEY ( ITM ): Strikes above than price of underlying with zero intrinsic value are called OTM(out the money) vice versa in put options.

3. RISK MANAGEMENT:

When trading options, effective risk management strategies are essential. Stop-loss orders can limit losses that could happen, and diversification helps reduce exposure to specific assets or industries. Additional protection can be provided by means of hedging strategies like purchasing options to cover potential losses.

IMPACT OF STOCK SPILTS ON OPTIONS TRADING

Before getting into the impact of stock splits options trading we need to know what are stock splits:- 

What are Stock Splits? 

Stock splits occur when a company decides to divide its existing shares into a greater number of shares. This action increases the number of outstanding shares while proportionally reducing the share price. Common stock splits include 2-for-1, 3-for-1, or even higher ratios. The primary purpose of stock splits is to make shares more affordable to individual investors and increase liquidity.

What is the impact of stock split?

When a stock split occurs, options contracts associated with the underlying stock undergo adjustments. Strike prices are typically adjusted to reflect the new share price, while the number of shares per contract is modified to maintain the same exposure. These adjustments ensure that the overall value of the options position remains unchanged after the stock split. However, the adjustments can result in changes to options premiums and trading dynamics.

CONCLUSION

In conclusion, options trading provides investors with unique opportunities to profit from price movements without owning the underlying assets. Stock splits, on the other hand, are corporate actions that divide existing shares to make them more affordable and increase liquidity. Understanding the effects of stock splits on options trading is crucial for options traders to effectively manage their positions and make informed decisions.

FAQs