Apple and Tesla are set to split their stocks at the end of August. For many investors who got into the market amid the coronavirus pandemic, the idea of splitting a stock can seem confusing. When a stock split is announced, options will have to undergo a process called "being made whole." What does that mean for investors with options?
What is a stock option?
Stock options give an investor the option, but not the obligation, to buy or sell a stock at an agreed-upon date and price. These can be calls, betting that the price of the stock will rise, or puts, betting that the price of the stock will fall. All of this is organized through an options contract, which is equal to 100 shares of the stock in question. The contract costs the investor a premium, whether they execute the stock option or not.
What happens to options during a stock split?
In the event of a stock split, options contracts will automatically go through a process called "being made whole." The process helps to ensure that the investor isn't affected by the stock split, regardless of whether it would have a positive or negative impact on the investor. There's a slightly different process depending on the type of split.
Forward split versus reverse split
During a forward split, like those that Tesla and Apple have planned, the investor is given more contracts at a lower price per stock. As an example, let's say that you bought an option controlling 100 shares in XYZ with a price of $100 per share. Following XYZ's announcement of a 5-for-1 stock split, the contract would automatically control 500 shares with each share now priced at $20.
A reverse split reverses this process. As an example, your options contract controls 100 shares in XYZ. Each share in XYZ is priced at $100 within your contract. Then, the company announces a 1-for-5 reverse stock split. Your contract will automatically be reduced from 100 shares to 20 shares with each share now priced at $500.