Stock splits have little effect on shareholders, but they have a very real effect on the options market.
Stock splits are all the rage lately.
On February 1st, 2022, Alphabet ($GOOGL, $GOOG) announced that it had approved plans for a 20:1 stock split — its first split since 2014. That night, shares of Alphabet soared 9% in after hours trading.
A month later on March 9th, Amazon ($AMZN) announced its first stock split since 1999. Mirroring Alphabet, the margin approved by Amazon was also 20:1. Upon the announcement, Amazon rose 6% after hours.
And today, March 28th, plans have leaked through a regulatory filing that Tesla ($TSLA) plans to request shareholder approval to conduct another stock split. Tesla last split in August of 2020, and since that date, shares of the EV company are up a whopping 128%.
While these splits don’t directly change the market cap or value of a company, they have an undeniable effect on the options market. First, let’s address the elephant in the room when it comes to stock splits.
“Stock splits don’t matter”
Whenever the topic of a stock split is broached, a familiar phrase can be heard. “Stock splits don’t matter.”, whether it’s through the talking heads on finance TV, or through popularly shared tweets like the one below.
$NVDA announced a 4-for-1 stock split!
Before everyone freaks out, let’s review how stock splits work again…
It’s one blob, except now it’s split into 4 smaller blobs
but it’s still the same amount of blob-matter
Thank you for coming to my blob talk pic.twitter.com/6806bxkJjV
— 𝐁𝐮𝐬𝐢𝐧𝐞𝐬𝐬𝐅𝐚𝐦𝐨𝐮𝐬 🇺🇦 (@BusinessFamous) May 22, 2021
But is that actually true? The answer is more complicated than that. Sure, the fundamentals do not change. The valuation does not change. The market cap doesn’t change. If you owned one share of Amazon before the split, the split will not add or reduce the value of those shares. Essentially, it’s like swapping out your $100 bill for five $20 bills.
Stock splits DO matter for options traders
Stock splits basically “don’t matter” for shareholders. However the same cannot be said of a stock split’s effect on the options market. For instance, though fractional shares exist, fractional options (on individual tickers) do not.
Market Rebellion Co-founder Pete Najarian briefly addressed the effect of making options more affordable during a recent appearance on CNBC’s Halftime Report.
“ open up the derivative markets. Something that was a $50 option that somebody probably couldn’t trade, can now be bought at a much lower cost. And along the way you can hedge on the downside, or you can do something for the upside.”
In Pete’s response, he mentions that traders looking for an affordable way to hedge their shares of an expensive stock are forced to battle with high-cost options. These can be more expensive than what the average trader is comfortable with, or can afford.
Stock splits tend to increase volume and implied volatility
An expensive options market also reduces liquidity, widens bid-ask spreads, and makes the option unwieldy, even for those who can afford them. Opening up the market to more potential buyers can have the opposite effect: more participation, more volume, and tighter bid-ask spreads.
Higher option volume can have an amplifying effect on implied volatility, which is directly related to the extrinsic value priced into an option. As the demand for an option rises, so does the implied volatility. But IV and volume are not the only options metric that stock splits have a direct effect on.
Stock splits have a direct effect on option greeks
The most important way that stock splits affect the options market is in the options greeks, particularly delta and gamma.
Option greeks are the metrics that determine how much an option is worth. Without getting too deep into the weeds, let’s quickly define these two greeks.
- DELTA: The rate of change in an option’s premium per $1 change in the underlying asset. Calls have positive delta, puts have negative delta.
- GAMMA: The rate of change in an option’s delta according to each $1 move in the underlying asset’s price.
To put it another way, delta is like the speed of an option’s change in price, and gamma is like acceleration of an options change in price.
But how do stock splits actually affect those metrics, and what does it mean for options holders? Let’s use an example to find out.
How stock splits affect delta and gamma
Imagine you’re holding one at-the-money $GOOGL call option at the $2800 strike, prior to the 20:1 split, with a delta of 0.50.
What happens to the delta when you hold through the 20:1 split? Now you own twenty $140 strike calls, all with a 0.50 delta. So even though the individual deltas have not changed, your total delta has risen by a factor of twenty, from just 50 all the way to 1000! That means that after splitting, the options in question are twenty-times more reactive to a $1 change in stock price.
Of course there is a counterbalance to this effect — a $1 change in a $2800 stock equates to a 0.035% change. A $1 change in a $140 stock equates to a .7% change. Still, this substantial change in total delta can make a massive difference for option holders, particularly those using multi-legged options strategies like spreads and condors.
The effects of a stock split on an options gamma are even more pronounced. Let’s revisit the above example of our at-the-money $GOOGL call option to find out why.
In the example, imagine that the at-the-money $2800 strike call option has a gamma of 0.002. That means that if you have a 0.50 delta, and the stock rises by $10, your option will gain two deltas, raising your total delta to 52! The same is true in reverse. If the stock falls by $1, you lost two delta, and now have a 48 delta option!
Now, you have a 20:1 split: what happens to your option gamma? You have twenty call options, at a $140 strike, and the gamma is multiplied by twenty, meaning the gamma is now 0.04 for each option. So now, you’ve have twenty-times as many options, and twenty-times as much gamma (from 0.002 pre-split to 0.8 post split), leading to an overall gamma increase of forty-times!
The bottom line: Are stock splits good or bad for my options?
The answer: neither! Stock splits are not bullish or bearish for the options market. That said, a stock split will make options more affordable, more liquid. Additionally, a stock split will likely make the options easier to use due to a reduction in slippage. Slippage refers to any time a trader pays a different execution price than they originally intended to, and is common among low-volume markets.
The change in delta and gamma isn’t bullish or bearish either. It simply means that the premium of the options in question become much more sensitive to changes in the price of the underlying stock. So if you’re holding options through a split, this article isn’t a call to sell them or to buy more. It’s simply a tool to help you understand how to make the most of your options trading experience. Understanding the subtle nuances that options create is part of what helps Market Rebels to trade smarter.