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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 intrigued 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.
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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?
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?
 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.
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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.
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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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