A stock split happens when a company decides to increase the number of outstanding shares. A stock can undergo a 2:1 split, a 3:1 split, even a 10:1 split; however it splits, the price of each share is adjusted by the same amount. In other words, if you own ABC stock at $50 and it splits 2:1, you will now have two shares valued at $25 each.
There are a lot of theories about why a company might choose to do so, considering it doesn’t change the overall market capitalization or other fundamentals. Some believe it’s a psychological tool to bring in new investment, the theory being that when a stock price breaks a certain point, say $100, it prices a certain type of investor out of the market, and bringing the price down will bring in new money.
Others believe it’s a valuable tool to increase liquidity and thereby tighten the bid-ask spread. Take Booking Holding, Inc. (BKNG): It’s currently trading around $1,700 with 46 million shares outstanding and an average daily volume of just over 500,000 shares. The bid-ask spread is well over $100.
Whatever the reason a company chooses, when a stock splits and you hold an options contract on that stock, the contract is adjusted so you are made whole. Any change in price due to the split won’t change the value of your contract.
For example, if you own options controlling 500 shares of XYZ at a strike price of $40 and the stock splits 2:1, you will now control 1,000 shares with a strike price of $20.
Occasionally, although far less frequently, a company will execute a reverse split, in which two or more shares will be combined into a single share. If you own options on this stock, you will again be made whole, only in reverse. So, in the example above, your options would now control 250 shares with a strike price of $80 in a 1:2 reverse split.
Stock splits generate a lot of buzz, but in all honesty, they are not that big of a deal, despite all the newsletters that prop up positive sentiment whenever a company announces one. Whether you own the stock outright or are trading options on it, you’re not really affected one way or another.