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Adjusted Options

What are adjusted options? What happens to options when companies are merged?


Adjusted Options - Definition


Non-standardized stock options with customized terms in order to price in major changes in the underlying stock's capital structure.

Adjusted Options - Introduction


Options traders were often excited when they discover stocks with more than one option of the same type, strike and expiration month but having different prices. In fact, some of these stock options are deep in the money but asking at a price which is way below its intrinsic value. Is the options trading market giving away free money? Definitely not. There is no such thing as free money in options trading and such options do not exist for no reason. These oddly priced options are known as Adjusted Options or Non-Standard options and this tutorial shall explain what they are.



How Does Adjusted Options Look Like?


Have you ever opened up your options chain and, to your surprise, see more than one option listed under a single strike price in the same expiration month like the options chain for BAC below?

Adjusted Options

Look at the options chain above for BAC's January 2010 options closely.

Do you see that there are 2 options listed under each strike price? For example, look at its $2.50 strike call options and you will see one with the symbol KGZAQ asking for only $0.30 while the other one with the symbol WBAAZ is asking for $5.80. Strange? BAC is trading at $7.80 at that point in time, so, should its $2.50 strike price call options be $5.30 in the money? If it is $5.30 in the money, then is KGZAO asking only for $0.30 is giving away $5.00 for free? Theoretically, you should be able to buy KGZAO for $0.30 and then exercise its rights to buy BAC shares at $2.50 and then be able to immediately sell the shares for its prevailing price of $7.80 and make an instant $5.00 profit ($7.80 - $2.50 - $0.30) right?

Isn't that giving money away for free?


OppiE's Note If you don't see these kinds of options in your options chains, then you have nothing to worry about because most options chains provided by brokers excludes adjusted options, which is a hint for you guys to stay away.

2 different options of different prices listed under the same month, type and strike has to be giving away money for free... or is it? Remember, there is no free lunch in options trading.




What are Adjusted Options


These non-standardized options with weird, tempting pricing are adjusted options and is excluded from options chains provided by online options trading brokers by default.

Adjusted options are created as a result of significant corporate activities such as mergers, acquisitions, spin-offs, stock splits, reverse splits or special dividends. In short, adjusted options are created as a result of changes in capital structure of a company that affects the capitalization or share value of its shares.

Whenever such significant changes happen to a stock, its stock options also need to be adjusted accordingly in order to reflect the new capital arrangement. Such an adjustment creates adjusted options with prices that cannot be determined by the conventional extrinsic / intrinsic value calculation.

Adjusted Options Example :

XYZ company shares were trading for $50 per share. Its $50 call options were asking for $2.00.

XYZ company spin-off a new company, ABC company, with $10 per share. In a spin-off, one company breaks up into two companies or more. No additional capital is created. Its just the same company becoming two or more. So, in this case, XYZ company's shares must be adjusted to $40 to reflect the new capital structure as $10 of capital has been allocated to ABC company.

Now what happens if you owned XYZ's $50 call options before the spin-off? Would you lose money now that XYZ shares are $40 instead of $50?

Not at all. The $50 call options will most likely still be $2.00 after the spin-off but now, it no longer converts to just shares of XYZ company but the combined shares of XYZ company and ABC company. So, before the spin-off, 1 contract of $50 Call options used to convert to 100 shares of XYZ company at $50 per share for $5000 worth of shares. After the spin-off, the $50 call options adjusted options would still convert to $5000 worth of shares but those shares would now comprise of 100 shares of XYZ company and 100 shares of ABC company.

In this example, the $50 strike adjusted call options would be asking for $2.00 even though it is $10 out of the money. Which looks like a big mispricing.

The same kind of adjustment happens during a stock split and other major events like a merger or acquisition but with different formulas. This makes the value of adjusted options extremely difficult to determine if you are not an assigned holder of the adjusted options due to owning the stock options before the adjustment.

No Free Lunch With Adjusted Options


As you can see above, even though those call options might look mispriced, they are actually correctly priced. Its just that the pricing policy and what it delivers is different from a standardized option. This means that if you open up your options chain and see an out of the money option asking for so high a price, you would not be able to make any profit by shorting it and holding it to expiration if the stock didn't move.

Yes, the biggest issue with adjusted options is the issue of options moneyness.

Determining if a certain adjusted option is in the money, at the money or out of the money requires doing more than just looking at the strike price in relation to the price of the underlying stock (because you cannot be totally sure of the deliverables for an adjusted option in the first place). In fact, adjusted options would never deliver 100 shares of the underlying stock like a standardized option would. It would either deliver more or less than 100 shares of the underlying stock or it would deliver more or less than 100 shares of the underlying stock plus shares of another stock or even cash itself.

Look at the BAC Jan2010 $2.50 Call options with symbol KGZAQ in the first example. Even though it has a strike price of $2.50, it is actually way out of the money in relation to what it is really based on. Mispricing happens in options trading but NEVER by margins of a few dollars. Adjusted options are not mispriced. They are just priced in a way which has little to do with its strike price in relation to the price of the underlying stock.

Deliverables of Adjusted Options


As you have understood above, Adjusted Options don't deliver 100 shares of the underlying per options contract like a regular standardized plain vanilla option. When major corporate events happen, the OCC, which is the Options Clearing Corporation, adjusts the options in order to ensure fair pricing and reflects the adjustments in a document such as the one you see below:

Click to See Options Adjustment Document from OCC
(Opens a new window)

In the example above, instead of 1 contract of the option (previously known as NX) delivering 100 shares of Quanex Building Products Corporation stock, it now delivers (under the new symbol of NBX) 100 shares of Quanex Building Products Corporation stocks PLUS $3,920 in cash!

Yes, after standardized options becomes adjusted options, it will commonly deliver either more or less shares of the underlying stock, shares of the underlying stock along with shares of another stock or it will deliver shares of the underlying stock along with cash. The problem is, you will never be able to tell just from looking at the options chain of the adjusted option itself. Such information can only be obtained from OCC. The complexity of calculating the value of adjusted options at any point in time makes adjusted options a poor choice of trading instrument for the non-professional.

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Sometimes, adjustment is not only made in adjusted options by changing the lot size or the deliverables, but can also be made to the strike price of the original options, resulting in listed options with odd strike prices.

Purpose of Adjusted Options


The purpose of Adjusted Options is to ensure fairness for holders of stock options going through major corporate events. It is not designed to be listed options for trading purposes even though they can be normally traded in an options exchange.

To illustrate the need for adjusted options, lets assume you hold call options in EFG company. One day, ABC company buys out EFG company so EFG company ceases to exist and EFG company stocks disappears from the exchange and becomes ABC stocks. In this case, without adjusted options, you would have lost all your money in the call options as the underlying stock, which is EFG, has ceased to exist. However, that is not fair to the options holders and not a good reflection of the capital reallocation that has happened. EFG company did not just disappear. It has been bought out by ABC company with part ABC stock and part cash. As such, to make sure the value of your call options is not affected, the old EFG call options that you are holding is given a new symbol and adjusted to deliver part ABC shares and part cash, like the example of Quanex Building Products Corporation above. You end up holding Adjusted Options.

The only kind of option that don't get adjusted during major corporate events are out of the money options. When an adjustment happens, extrinsic values of the original options becomes zero instantly. This means that all out of the money options instantly expire worthless and all the extrinsic value of in the money options evaporate instantly as well. Due to this reason, holders of stock options before adjustment cannot be expected to retain 100% value of their original holding and holders of out of the money options before adjustment would have lost their investments.

Why You Shouldn't Trade Adjusted Options


As mentioned before, adjusted options are assigned to holders of standardized options before a major corporate event. However, these adjusted options remain available for trading in the options exchange, which confuse a lot of options traders. If you see adjusted options (you can recognize them by their big "mispricing"), you should not buy them in order to speculate in the underlying stock going a certain way because of the following reasons:

1. They are very illiquid. Very few people, if any at all, trades adjusted options in the open market. In fact, most options trading brokers don't present adjusted options in their options chains by default.

2. They usually have very wide bid ask spreads. This is because market makers are going to have a hard time clearing their inventory of these adjusted options and will want to make as big a profit as possible from every trade in order to justify their efforts and committment.

3. Adjusted Options don't move exactly as the underlying stock does. The underlying asset for adjusted options are not always shares in the underlying stock and it can be extremely complex to work out the net changes.

4. Difficulty in Valuation. It can be extremely complex to work out the exact value of an adjusted option especially if the company has undergone extremely complex capital re-structuring. In fact, the method for adjustment can be different for the same corporate event in different context.

If you are holding adjusted options because you held options through a major corporate restructuring, the best thing to do may be to simply exercise them for the deliverables.

Advantages of Adjusted Options


:: Ensuring fairness for options holders.

Disadvantages of Adjusted Options


:: Less liquid market available for adjusted options.
:: Complexity in determining the value of the resulting adjusted options.
:: Losses can occur in the adjustment process due to elimination of extrinsic value.


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