Proposed Contract Adjustment Changes To Eliminate Rounding - Revised

Discussion in 'Options' started by freehouse, Jan 12, 2006.

  1. DATE: JANUARY 9, 2006

    The OCC Board of Directors recently approved a change in the way contract adjustments are
    executed for a wide variety of stock splits and distributions. The proposed change
    represents a significant departure from long-standing practice. The change will be
    effective on a date to be announced following SEC approval and distribution of a supplement
    to the Options Disclosure Document (see “Effective Date” below).

    Background and Rationale

    Currently, Article VI, Section 11 of OCC’s By-Laws specifies two alternative methods of
    adjusting for stock splits and stock dividends. In cases where one or more whole shares are
    issued with respect to each outstanding share, the number of outstanding option contracts is
    correspondingly increased and strike prices are proportionately reduced to reflect the split
    ratio. For example, in the event of a 3-for-1 split, an XYZ 60 option calling for the delivery of
    100 shares of XYZ stock would be divided into three XYZ 20 options, each calling for the
    delivery of 100 shares of XYZ stock.

    In all other cases, the deliverable and premium/strike multiplier are increased, and strike prices
    are reduced. For example, in a 3-for-2 split, an XYZ 40 option calling for the delivery of 100
    shares would be adjusted to a new adjusted option symbol that would call for the delivery of
    150 shares with a reduced strike price of 26 5/8 (40 / 1.5 = 26.6666, rounded to the nearest
    eighth). The new adjusted option symbol would also have a premium/strike multiplier of 150.

    Since equity option strike prices are currently denominated in eighths, adjusting strikes
    according to either of the methods mentioned above will periodically require rounding of
    adjusted strikes to the nearest eighth. The need to round to the nearest eighth results in
    economic inequities measured in terms of the in-the-money value of positions after the
    adjustment. These inequities due to rounding have historically been accepted as immaterial.
    Recently, however, they have become a source of concern to exchanges and market
    participants. Over the years, option trading volume and open interest have increased
    significantly. Larger positions, sophisticated trading techniques, and spread strategies can
    easily magnify small single-contract rounding inequities into sizeable amounts. The OCC
    Board of Directors has determined it desirable to implement an adjustment method that will
    eliminate rounding inequities that arise solely as an artifact of the adjustment process.

    New Method

    The need for rounding strike prices can be avoided by using a different adjustment
    methodology - adjusting the deliverable but not the strike price or premium/strike
    multiplier (the “New Method”). Going back to the example of the 3-for-2 stock split, it would
    be possible to adjust outstanding XYZ options to call for the delivery of 150 shares of XYZ
    stock, leave the strike price at 40, and continue to use 100 as the “multiplier” for calculating
    premiums and extended strike prices. This would eliminate the need for rounding because the
    strike price would remain unchanged (see examples below). This is the method currently used
    for property distributions such as spin-offs, mergers, or stock dividends with cash in lieu of
    fractional shares. This method can simply be extended to cover a wider variety of contract

    The basic features of all adjustments under the New Method are:
    a) Strike prices remain unchanged.
    b) The additional shares are added to the contract deliverable.
    c) The adjusted option continues to use 100 as the multiplier to extend premium
    and strike amounts.
    d) The number of contracts remains the same.

    The change approved by the OCC Board of Directors was described in an OCC Information
    Memo earlier this year (Memo #20872). In response to comments from Clearing Members and
    option exchanges, the OCC Board modified its original approach to provide operational
    efficiencies. The modified and current proposal is as follows: With the exception of 2 for 1
    and 4 for 1 stock splits, all contract adjustments in response to splits or stock
    distributions shall be done using the “New Method”. Because 2 for 1 and 4 for 1 splits are
    not likely ever to require rounding of strikes to eighths, these events would be handled using
    current methods. (In the case of 2 for 1 and 4 for 1 splits, if rounding of strike prices would
    otherwise occur in a contract adjustment using current methods, then the “New Method” of
    contract adjustment shall be used for these splits as well. The New Method would be used if
    any strike price would otherwise require rounding, and would be applied to all strikes of the
    option to be adjusted.)

    OCC notes that inequities due to rounding would not present a problem if option strike prices
    could be denominated in decimals (pennies). OCC’s systems can presently accommodate
    decimal strike prices, but OCC is aware that many industry participants cannot. OCC’s Board
    intends that the new adjustment method to avoid rounding will be an interim solution – until
    such time as the option industry can accommodate decimal strike prices for equity options.
    Accordingly, the New Method will apply only to equity options denominated in fractions.

    Effective Date

    This change in adjustment methodology requires a change in the OCC By-Laws which must be
    approved by the Securities and Exchange Commission. Also, a supplement to the Options
    Disclosure Document describing the change will need to be distributed. The New Method of
    option adjustment will not be implemented until these events have occurred. OCC estimates a
    minimum of 4-5 months will be needed. OCC will provide advance notice of the effective date
    for the New Method as soon as practicable. OCC understands the option exchanges will also
    be publishing notices and providing educational efforts to prepare for this change.

    Important Option Trading Considerations

    It will be important for option investors to realize that after adjustments are made using the
    New Method, it will no longer be possible to determine if an adjusted option is in- or
    out-of-the-money by simply comparing the underlying stock price to the option strike
    price. For example, returning to the example of the 3 for 2 split (see above), if an investor
    simply compared the adjusted strike to the underlying stock price – as an investor does under
    current adjustment methodology - the investor might erroneously assume that with a stock
    price of 28, an adjusted XXX 40 Call option is 12 points out-of-the-money (40 – 28 = 12).
    Actually, that option series is 2 points in-the-money: deliverable value of $28 x 150 = $4200,
    versus the strike value of $40 x 100 = $4000. In this case, an option trader wishing to bid the
    in-the-money amount would bid “2” or $200 ($2 x 100, the premium multiplier). After the New
    Method is effective, option investors must always be aware of the number of shares in
    the deliverable and the multiplier used for premium and strike dollar extensions.

    Although this trading consideration resulting from the New Method is an important change for
    the split adjustments, it is already familiar to the options industry, as this methodology for
    adjustments has long been used for spinoffs and mergers. In these kinds of adjustments -
    which often involve multiple stock components in the deliverable, unusual share amounts
    and/or cash components – it is also not possible to determine in- or out-of-the-money value by
    simply comparing a single stock price to the strike price. (Also in these cases, the
    premium/strike multiplier remains 100.)
  2. You mention very important concerns. Seemingly, there will be many uninformed who will be making mistakes. People who trade options must patiently review these changes and understand them well.