Question & Answer

This is a level 3 question.

Q:  

When trying to play a stock split with a record date before expiration (for example, in October) and a payable date after expiration (for example, November), this requires that you hold either October or November calls. Which option series will receive the two-for-one split, and which offers the most potential if you think the underlying stock will run up before and just after the split? Would that be the November calls?

A:  

First of all, let's explain what a stock split is and what it does to a company. A (two-for-one) stock split is a dividend that increases the number of shares. After a two-for-one stock split, you'll have two shares for every one that you currently own.

So how does this impact an investor? Let's assume that an investor owns 200 shares of XYZ Corp. and that it will split at 180. Before the split, the shareholder's value of XYZ is $36,000. If the shareholder continues to hold XYZ stock as of the record date, he or she will be considered the holder of record and his or her shares will be counted as part of the two-for-one split. On the payable date, the shareholder will collect their extra 200 shares and will have a total of 400 shares of XYZ at the new price of 90. The shareholder's value will still be $36,000 (400 shares x 90). Nothing of real consequence happens to the shareholder.

For the company, on the day after the pay date, the stock's market price is reduced by the amount of the dividend. After the record date, the stock is considered ex-dividend although the dividend won't be paid out until the pay date. When a company issues a stock dividend, it retains its accumulated earnings. Therefore, some companies may want to issue a stock dividend to avoid paying out cash. They may want to use the cash elsewhere. Basically, the company is capitalizing its earnings.

Generally, one of the reasons why a company splits its stock is to make it more attractive for investors to purchase. It is purely a psychological phenomenon in which people like to buy a company at a bargain or discount from its former higher levels. Also, there is some thought that it broadens the shareholder base, which makes the stock more liquid and appealing. This is because potentially smaller shareholders now can afford the shares at the reduced price.

What happens if stock is purchased between the record date and the payment date? In this case, one of two possibilities could arise. The first and most likely is that you will pay the pre-split price and when the payment comes you will be credited with the additional shares. The stock is sometimes traded on a when-issued basis. In this case, there are then effectively two classes of stock being traded. One class is traded with the split, and one is traded without the split. You'll have to specify which you want to purchase.

Supposedly, some investors have been able to design option strategies surrounding the declaration and record dates. However, most investors are unable to take advantage of these strategies. In addition, there is no guarantee that the stock will continue to rise after the stock split. Generally, some traders use a strategy of buying shares or options of companies splitting the day of the announcement and then selling them shortly thereafter. Normally, the announcement is enough to elicit a rise in the stock, especially on widely held stocks. This move can often be dramatic and may last for several sessions. Frequently, some days after the announcement, the price drifts back down whereupon traders reverse their positions and go short or buy puts on the stock. Then, five to 10 trading days prior to the record date, another wave of buying comes in and the price decline is reversed. Now, a new pre-split run-up begins, which can continue through the record date.

So to answer your question, if you were to trade options on XYZ, the October series could possibly catch a run up, but it won't capture the split. In theory, you could exercise a call on expiration Friday and that would entitle you to XYZ shares. In this case, you would be looking at the scenario described above concerning purchasing stock in between the record date and pay date.

As for the November options, they will see the two-for-one split reflected in their dealings. In this case, if you were long one November 150 call, you now would be long two November 75 calls. This is because the option strike and their prices will reflect the dividend (split) pay out.

Remember, there is no guarantee that the stock will continue to rise in price after the split. If there were such a guarantee, we would all get rich buying options on the day the stock splits and selling them at higher levels when the stock moved up. Remember to do a thorough analysis of the stock and don't base it solely on the stock split itself, but rather on the technical, fundamental, and sentiment picture. Many times a stock declines after a split.

We appreciate your question, and wish you good luck with your trading.

 

Question Level Key

Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of other topics.

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