Investments, tenth edition

  Adjustments in Option Contract Terms 

 Because options convey the right to buy or sell shares at a stated price, stock splits would 

radically alter their value if the terms of the options contract were not adjusted to account 

for the stock split. For example, reconsider the IBM call options in  Figure 20.1 . If IBM 

were to announce a 2-for-1 split, its share price would fall from about $195 to about 

$97.50. A call option with exercise price $195 would be just about worthless, with virtu-

ally no possibility that the stock would sell at more than $195 before the options expired. 

 To account for a stock split, the exercise price is reduced by a factor of the split, and the 

number of options held is increased by that factor. For example, each original call option 

with exercise price of $195 would be altered after a 2-for-1 split to two new options, with 

each new option carrying an exercise price of $97.50. A similar adjustment is made for stock 

dividends of more than 10%; the number of shares covered by each option is increased in 

proportion to the stock dividend, and the exercise price is reduced by that proportion. 

 In contrast to stock dividends, cash dividends do not affect the terms of an option con-

tract. Because payment of a cash dividend reduces the selling price of the stock without 

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  Options Markets: Introduction 

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inducing offsetting adjustments in the option contract, the value of the option is affected by 

dividend policy. Other things being equal, call option values are lower for high-dividend 

payout policies, because such policies slow the rate of increase of stock prices; conversely, 

put values are higher for high-dividend payouts. (Of course, the option values do not nec-

essarily rise or fall on the dividend payment or ex-dividend dates. Dividend payments are 

anticipated, so the effect of the payment already is built into the original option price.) 

 

 

 Suppose that IBM’s stock price at the exercise date is $200, and the exercise price of the call is $195. What is 

the payoff on one option contract? After a 2-for-1 split, the stock price is $100, the exercise price is $97.50, 

and the option holder now can purchase 200 shares. Show that the split leaves the payoff from the option 

unaffected. 

 CONCEPT CHECK