Zen asked in Business & FinanceInvesting · 1 decade ago

Will a reverse stock split add risk to my options position?

For example: a company announced a 1:6 reverse split. Let's say I have a bull call spread for a debit of $1 and thus I have a total risk of $100 per contract. Does it mean that after reverse stock split, my risk will turns out to be $6 which is $600 per contract?

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  • 1 decade ago
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    <<<Will a reverse stock split add risk to my options position?>>>

    No. When a (reverse) stock split occurs the options are adjusted to reflect the split. The underlying will become the same thing that the owner of 100 pre-split shares shares received. For an example, when AIG had a 1:20 reverse split recently the options were adjusted to make the underlying 5 shares of the post-split shares.

    http://www.cboe.com/publish/TTStockSM/09-242.pdf

    <<<Let's say I have a bull call spread for a debit of $1 and thus I have a total risk of $100 per contract.>>>

    We can assume that, but I do not see how you would have expected risk to increase with that example. I do see how you could have thought risk might increase if you had a credit spread instead of a debit spread, so I will go though both a credit spread and a debit spread.

    <<<Does it mean that after reverse stock split, my risk will turns out to be $6 which is $600 per contract?>>>

    No. Let's go through examples assuming the following was true pre-split:

    Stock price: $3.25

    Price to open a $2.50-$5.00 bull call spread: $1.00 debit.

    Price to open a $2.50-$5.00 bull put spread: $1.50 credit.

    (Both spreads have a max risk for $100 per contract and a max profit of $150 per contract.)

    If a 1:5 reverse split took place the math is easy so I will go through an example assume a 1:5 reverse split first. Assuming the adjustment was done in the same manner as the AIG adjustment, the strike prices would technically remain the same, the underlying would become 20 shares instead of 100 shares, and the mulitplier would remain at 100. So, if a $2.50 strike price option is exercised, 20 shares would trade for $2.50 x 100 = $250 and if a $5.00 strike price option is exercised 20 shares would trade for $5.00 x 100 = $500. The dollar amounts per trade do not change because of the reverse split, so the number of dollars at risk do not change. It is, however, important to note that the effective strike prices are no longer the strike prices listed for the options. The $2.50 strike price will effectively become a $250 / 20 = $12.50 strike price and the $5.00 strike price will effectively become a $500 / 20 = $25.00 strike price.

    Bull call spread max risk = $100 (cost to open) per contract

    Bull call spread max profit = $500 - $250 - $100 = $150 per contract

    Bull put spread max risk = $500 - $250 -$150 = $100 per contract

    Bull put spread max profit = $150 (credit to open) per contract

    If a 1:6 reverse split takes place the same principles apply but it is slightly complicated because 100 is not evenly divisable by 6. To make the adjustment as fair as possible, the adjustment would make the underlying 16 post-split shares plus $3.25 x 4 = $13.00 cash. [(16 x 6) + 4 = 100]

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