Explore Your Options  |  FEB 2010

Explore Your Options by Tom Gentile

Explore Your Options by Tom Gentile ""SPLITTING"" HEADACHE Can you please explain how a 3-for-2 stock split affects the pricing of options? I saw a split of this type and couldn’t get my head around the math. Great question. Before we jump into this complicated kind of split, though, let’s begin with the typical 2-for-1 so readers not familiar with the basic mechanics can get up to speed. The 2-for-1 split involves adjusting the old strike price and presplit option premium in half. Also critical, the amount of contracts held long or short will be doubled. This adjustment process allows the aggregate market value or cost basis of the position to be maintained relative to the value of the position prior to the split. We need to multiply the adjusted contracts by the new premium, which has been reduced by 50% (with shares flat) to compare and confirm the risk and cost basis of the pre- and postsplit positions are the same. In dealing with a 3-for-2 split or any split where “1” isn’t the denominator, traders need to approach the option differently in order to confirm the cost basis is still the same. In these situations, we need to use a nonstandard “hidden” multiplier other than the typical $1.00 per contract = $100.

by Tom Gentile