What are Option contract adjustments?

Events or activities like mergers, splits, take-overs and announcements of dividends, bonus etc., in a company has a significant impact on the price of its stocks. When stocks are impacted, its derivative Options also get impacted. Options contract adjustments are done to account for the corporate event or action and to ensure that there is no change in the value of the Option contract due to the corporate action. What corporate actions or events necessitate Options adjustments? Corporate actions or events that require Options adjustments are- Mergers Amalgamation Splits Reverse Splits Takeovers Acquisitions High Dividend announcements What Option adjustments mean? According to SEBI regulations, Adjustments means modifications to positions and or contract specifications so that the value of the position of the buyers and sellers shall continue to remain the same as far as possible. The Options adjustments shall be carried out on any or all of the following components of the contract depending on the nature of the corporate action- Strike Price Position Market Lot / Multiplier The adjustments are carried out on all open, exercised as well as assigned positions. How Options adjustments are done? There are standard guidelines laid out by SEBI for Options adjustments for Bonus, Stock Splits and Consolidations. To make an adjustment in the Option contract, SEBI has suggested formulas to arrive at the adjustment factor. The new value of various components of the option contract like strike price, market lot and positions etc., are then arrived by factoring in the adjustment factor. Here’s how the adjustment factor for Bonus, Stock Splits and Consolidations is calculated: Bonus Stock Splits and Consolidations Right Ratio – A : B Adjustment factor= (A+B)/B Ratio – A : B Adjustment factor : A/B Ratio – A : B, New Strike Price= ((B * X) + A * (C + D))/(A+B) Existing Market Lot / Multiplier / Position= Y New issue size= Y *(A+B)/B Where Premium – C Face Value – D Existing Strike Price- X Once the adjustment factor is calculated based on the above methodology, the new values of the contract components are calculated as- New Strike Price= Old Strike Price/Adjustment Factor Market Lot / Multiplier= Old market lot * adjustment factor New Position= Old position * adjustment factor as under How to know if an option contract has been adjusted? There are certain indicators to know whether an option contract has been adjusted: The option is either too cheap or too expensive There are two different symbols for the Options of the same month and strike price. The liquidity of adjusted Options is lower than other Options