A company’s stock price reacts to corporate actions such as special dividends, stock splits and stock dividends (also called bonus shares). What about the derivatives on a stock? This week, we discuss the impact of the issue of bonus shares on options contracts.

Status quo position?

Suppose you buy the 500-strike call on a stock. Later, suppose the company announces a one-for-one bonus share. You are entitled to the bonus shares only if you are a shareholder on the record date announced by the company. The ex-bonus date is fixed by the exchange such that you are entitled to the corporate action if you buy the shares before the ex-bonus date.

The stock price, most likely, declines ex-bonus as you are no longer entitled to the bonus shares. This necessitates an adjustment to the option’s strike price. Why? When you buy the 500 call, you purchase the right but not the obligation to buy the underlying at 500 per share. You can exercise this right only at contract expiry, as NSE offers European options. But the underlying would have declined because of the corporate action, a development that is not the same as change in the company’s business outlook or factors that affect the entire market. Why?

According to the NSE, option contracts are adjusted for corporate actions so that the value of the positions before and after the ex-bonus date remains the same as far as possible. Traders take positions based on how a likely event can affect the price of an underlying or its derivatives. This is not the case with corporate actions. The record date is known in advance and market participants are aware that a stock typically declines ex-bonus, although the magnitude of the impact is unknown. For instance, last June, REC announced one bonus share for every three shares held (1:3). The record date was August 18 and NSE fixed August 17 as the ex-bonus date. If you had bought the shares on August 16, you would be entitled to the bonus shares. But what if you held 110 call that was set to expire on August 25, the last Thursday of the month? Holding an option does not entitle you to bonus shares. Yet, your option is impacted by the corporate action; the fall in the underlying price ex-bonus will affect the moneyness (intrinsic value) of the option. For instance, the 110 strike on REC would have expired out-of-the-money (OTM) because of a known event, namely issue of bonus shares, necessitating an adjustment to the option contract.

Optional reading

Both the option strike and its permitted lot size must be revised based on an adjustment factor, which for REC was 1.3333, determined as (1+3)/3 based on the 1:3 ratio. So, the revised strike was 82.50, the old strike price divided by the adjustment factor (110/1.3333) and revised permitted lot size was: Existing contract size (6000) times adjustment factor (1.3333) = 8,000.

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