What are the Impacts of Corporate Actions and Non-Standard Options on Trading Strategies

Corporate Actions and Non-Standard Options: Understanding the Impact on Your Trading Strategies

Corporate actions are significant events initiated by a company that can affect its stock price and, consequently, the options tied to that stock. These events can lead to the creation of non-standard options, which differ from the typical options contracts in terms of strike price, expiration, and the underlying asset. Understanding how corporate actions lead to non-standard options and how these changes impact your trading strategies is crucial for successful options trading. This article provides a comprehensive guide on corporate actions, non-standard options, and the implications for traders.

What Are Corporate Actions?

Corporate actions are events undertaken by a corporation that directly affect its securities, including stocks and bonds. These actions can be voluntary or mandatory and can significantly impact the value of the company's stock, the company's structure, and, by extension, any options tied to the stock.

Types of Corporate Actions:

1. Dividends:

   • Definition: Dividends are payments made by a corporation to its shareholders, usually in the form of cash or additional shares. Dividends are typically declared on a per-share basis.
   • Impact on Options: When a company pays a dividend, especially a large one, it usually results in a decrease in the stock price by the dividend amount on the ex-dividend date. This drop in stock price can affect call and put options, particularly those that are nearing expiration.

2. Stock Splits and Reverse Stock Splits:

   • Stock Split: A stock split increases the number of shares outstanding by issuing more shares to existing shareholders. For example, in a 2-for-1 split, each shareholder receives an additional share for every share they own, effectively halving the stock price.
   • Reverse Stock Split: A reverse stock split decreases the number of shares outstanding, increasing the stock price. For example, in a 1-for-2 reverse split, shareholders exchange two shares for one, doubling the stock price.
   • Impact on Options: Stock splits and reverse stock splits lead to adjustments in the options contracts. The number of options contracts held may increase or decrease, and the strike price and contract size are adjusted accordingly to reflect the new stock price.

3. Mergers and Acquisitions (M&A):

   • Definition: Mergers and acquisitions occur when one company is absorbed by another or when two companies combine to form a new entity. These actions can involve cash, stock, or a combination of both as compensation to shareholders.
   • Impact on Options: Mergers and acquisitions often result in changes to the underlying asset of the options contract, such as replacing the original stock with the acquiring company's stock or converting the options into cash-settled contracts.

4. Spin-Offs:

   • Definition: A spin-off occurs when a company creates a new independent company by distributing new shares of its subsidiary to its existing shareholders.
   • Impact on Options: Spin-offs typically lead to adjustments in the options contract to account for the new stock distribution. This can result in a situation where the original option now includes the right to purchase or sell shares of both the parent and the new company.

5. Rights Offerings:

   • Definition: In a rights offering, a company gives existing shareholders the right to purchase additional shares at a discount before the shares are offered to the public.
   • Impact on Options: Rights offerings can result in the creation of non-standard options contracts, as the options will need to reflect the rights issued along with the underlying shares.

What Are Non-Standard Options?

Non-standard options, also known as adjusted options, are options contracts that have been modified due to corporate actions. Unlike standard options, which typically represent 100 shares of a stock with a fixed strike price and expiration date, non-standard options may have different terms to account for changes in the underlying asset.

Key Characteristics of Non-Standard Options:

1. Adjusted Contract Size:

   • Non-standard options often have a contract size that differs from the standard 100 shares. For example, after a stock split, a contract might cover 150 shares instead of 100.

2. Modified Strike Prices:

   • The strike price of non-standard options is adjusted to reflect changes in the stock price due to corporate actions. For example, after a 2-for-1 stock split, the strike price of call and put options would typically be halved.

3. Complex Underlying Assets:

   • Non-standard options may be tied to more than one underlying asset. For example, after a spin-off, the options contract might be adjusted to include both the original stock and the newly spun-off company’s stock.

4. Cash Settlements:

   • In cases like mergers and acquisitions, where the underlying asset is converted into cash, the non-standard option may become a cash-settled contract instead of a physically settled one.

5. Different Expiration Terms:

   • The expiration terms of non-standard options may differ from standard options, particularly if the corporate action involves a specific future event, such as a merger completion date.

How Corporate Actions Lead to Non-Standard Options

When a corporate action occurs, the Options Clearing Corporation (OCC) typically intervenes to adjust the terms of existing options contracts to ensure that they reflect the changes in the underlying asset. Here’s how some common corporate actions lead to non-standard options:

1. Stock Splits and Reverse Splits:

   • When a stock split occurs, the OCC adjusts the number of options contracts and the strike price to reflect the new number of shares and the adjusted stock price. For example, in a 2-for-1 stock split, the number of contracts would double, and the strike price would be halved.

2. Mergers and Acquisitions:

   • In an M&A scenario, the OCC may adjust the options contracts to reflect the new shares of the acquiring company, or the contracts may be converted to cash-settled options if the acquisition is for cash. In cases where shareholders receive a mix of cash and stock, the options may be adjusted to reflect this mix.

3. Spin-Offs:

   • For a spin-off, the OCC will adjust the existing options contracts so that they cover both the parent company’s stock and the newly spun-off company’s stock. This adjustment ensures that the options holder retains the value of the original contract.

4. Dividends:

   • For large, special dividends, the OCC may adjust the strike price of the options to reflect the drop in the stock price on the ex-dividend date. However, for regular dividends, no such adjustment is typically made.

Implications for Traders

Understanding how corporate actions lead to non-standard options is crucial for traders, as these adjustments can significantly impact the value of their positions. Here are some key implications for traders:

1. Changes in Risk and Reward:

   • Non-standard options can alter the risk-reward profile of a trade. For example, an adjusted strike price or contract size may change the breakeven point of a trade or the potential profit.

2. Complexity in Valuation:

   • Valuing non-standard options can be more complex than standard options, particularly when the underlying asset includes multiple stocks or a mix of cash and stock. Traders need to carefully assess the new terms of the option to determine its fair value.

3. Liquidity Concerns:

   • Non-standard options may be less liquid than standard options, as the adjusted terms can lead to less interest from other traders. Lower liquidity can result in wider bid-ask spreads and more difficulty in entering or exiting positions.

4. Tax Implications:

   • Corporate actions and the resulting non-standard options can have tax implications. For example, a cash-settled option may trigger a taxable event, while stock splits or spin-offs may have different tax consequences. Traders should consult with a tax advisor to understand the potential impact.

5. Strategic Adjustments:

   • Traders may need to adjust their strategies when dealing with non-standard options. For example, a covered call strategy might need to be modified if the number of shares covered by the option changes due to a stock split.

Conclusion

Corporate actions can significantly impact options trading, leading to the creation of non-standard options with adjusted terms. Understanding how these actions affect your options contracts is essential for managing risk and optimizing your trading strategy. By staying informed about corporate actions and how the OCC adjusts options contracts, traders can better navigate the complexities of non-standard options and make more informed trading decisions.

Frequently Asked Questions (FAQs)

1. What are non-standard options?

Non-standard options, also known as adjusted options, are options contracts that have been modified due to corporate actions such as stock splits, mergers, or spin-offs. These contracts may have different strike prices, contract sizes, or underlying assets compared to standard options.

2. How do stock splits affect options contracts?

In a stock split, the number of shares represented by an options contract increases, and the strike price is adjusted accordingly. For example, in a 2-for-1 split, the number of contracts would double, and the strike price would be halved.

3. What happens to options during a merger or acquisition?

During a merger or acquisition, options contracts may be adjusted to reflect the new shares of the acquiring company or converted into cash-settled options if the acquisition involves cash. The terms of the options are modified to ensure the value is preserved.

4. How do spin-offs impact options trading?

In a spin-off, the existing options contracts are adjusted to include the shares of the new company along with the original parent company. This adjustment ensures that the options holder retains the full value of their contract.

5. Are non-standard options less liquid than standard options?

Yes, non-standard options can be less liquid than standard options because the adjusted terms may result in less interest from other traders. This reduced liquidity can lead to wider bid-ask spreads and more difficulty in trading the options.