What You Should Know About Dividends and Splits for the Series 7 Exam
The Series 7 will doubtless expect you to know how an option contract is adjusted for corporate actions such as a company declaring a dividend or splitting its stock. Begin with the basics and move forward from there.
When a company declares a stock dividend, here’s what happens to option contracts:
The number of option contracts remains the same.
The strike price decreases.
The number of shares per option contract increases.
Please peruse the following example to see how this works out. Here, the investor’s initial position is
4 ABC Sep 65 call options (100 shares per option)
If ABC declares a 5-percent stock dividend, you can find the investor’s position on the ex-dividend date (the first day the stock trades without the dividend).
Because ABC is giving a 5-percent stock dividend, the result will be 105 shares per option instead of 100 (5 percent more shares). To find the new strike price, multiply the original 65 call options by 100 shares per option to get 6,500. Next, divide the 6,500 by the 105 shares per option to get a new strike price of 61.90 (rounded to the nearest cent). The new position is
4 ABC Sep 61.90 call options (105 shares per option)
Cash dividends do not affect listed options. For example, suppose that an investor owns 1 ABC Oct 40 call option and ABC declares a $0.50 cash dividend. Although the price of the stock decreases by $0.50, the option still reads 1 ABC Oct 40 call.
Regular forward splits
Dealing with a regular forward split is relatively easy. In this case, you’re dealing with a 2-for-1, 3-for-1, 4-for-1, and so on. In an anything-for-1 split, here’s what happens:
The number of option contracts increases.
The strike price decreases.
The number of shares per option remains the same (normally 100).
Check out the following example, where the investor has an initial position of
2 DEF Jul 60 calls (100 shares per option)
If DEF Corporation announces a 3-for-1 split, the investor’s position on the ex-dividend date is
6 DEF Jul 20 calls (100 shares per option)
In this case, the investor has three options for every one that she had before, and the strike price is 1⁄3 of what it was before:
Notice how you multiply the contracts by 3⁄1 and the strike price by the reciprocal (1⁄3).
A good way to double-check your work for all dividends and splits is to multiply the number of option contracts by the strike price and then by the number of shares per option. Do the same things after you adjust the numbers for the dividend or split. Compare the answers. You should get the same number. If you don’t, you did something wrong.
Uneven and reverse splits
Uneven splits are similar to dividends in that the number of option contracts remains the same but the strike price and the number of shares per option change. Uneven splits are splits that are not x-for-1 (for example, 3-for-2, 4-for-3, 5-for-2, and so on). Look at the following example, where the investor has an initial position of
3 GHI Jun 50 calls (100 shares per option)
If GHI announces a 5-for-2 split, the investor’s position on the ex-dividend date is
3 GHI Jun 20 calls (250 shares per option)
First, because the investor has 5 shares for every 2 that she had before, you have to multiply the shares per option by 5⁄2:
100 shares × (5/2) = 500 shares ÷ 2 = 250 shares per option
Next, you have to multiply the strike price by 2⁄5:
50 strike price × (2/5) = 100 ÷ 5 = 20 new strike price
To work out a reverse split (for example, 3-for-5, 2-for-3, and so forth), use the same process. Be aware that for reverse splits, the strike price increases and the shares per option decrease.