Contract adjustments for covered call writing and put-selling are not uncommon events and we must be prepared when they occur. From time to time a certain corporate event will take place that will alter the terms of an equity options contract, making it different from the original standardized terms such as the number of deliverable shares.
Let’s first list some of the most common events that lead to contract adjustments:
When a special 1-time cash-dividend is distributed option contracts will be adjusted to make both buyers and sellers of option contracts “whole” Generally, call options will move down in value by the amount of the dividend and put options will increase in price. The holder of a call option will be made “whole” by decreasing the strike price by the amount of the 1-time distribution. Let’s assume a stock is trading at $50.00 per share and a special 1-time cash dividend of $1.00 goes ex-dividend (date by which shares must be owned to be eligible to receive the dividend). The price of the stock will drop by $1.00, all other factors remaining the same. This is not fair to a call buyer so the strike is adjusted accordingly, by $1.00 in this hypothetical. A $50.00 call strike price is changed to a $49.00 strike price. In certain situations, the dividend distribution is less than the announced amount and the strike reduction is also less than the expected adjustment. This is the case with American Depository Receipts (ADRs).
What are American Depository Receipts (ADRs)?
These are negotiable certificates issued by U.S. banks representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction. Since there is now a “middle-man” involved in these trades, there is frequently a fee imposed by the bank to administer these 1-time special dividends. This means that the net amount received would be less than the announced distribution. In the above example, if the net dividend was $0.98 instead of $1.00, the $50.00 strike would be adjusted to $49.02.
Real-life example with New Oriental Education & Technology Group (NYSE: EDU)
EDU is a Chinese company trading on the New York Stock Exchange as an ADR. On 9/1/2017 the company went ex-date with a special 1-time cash dividend of $0.45-per-share. The bank administering the transaction imposed a $0.02-per-share fee making the net distribution $0.43-per-share. Strike prices were adjusted by the net amount, not the announced distribution amount. This explains the unusual strike prices shown in the screenshot below:
As with all contract adjustments, buyers and sellers of both calls and puts are made “whole” as a result of these alterations. Contract adjustments are not all managed in the same manner so it is important to research or inquire when we see unusual strike prices. Some excellent free sites include:
Contract adjustments are alterations made in our option contracts in response to a corporate action. Special 1-time cash dividends frequently will result in a change in strike prices. For ADRs, the net amount is the key to both the dividend received and the strike change.
Market conditions (opinion)
For many of us, recent market declines and enhanced volatility are unsettling but something we have experienced in the past multiple times. For new members, sleeping at night may be a challenge. I am currently fully invested and managing my positions as detailed in the BCI methodology. Only you can determine whether it is appropriate to remain fully invested or move to cash to some extent. All positive economic data is in place for continued corporate sales and earnings growth. The market is reacting to possible trade wars, the projected number of interest rate hikes, concerns of more vigorous US military involvement and uncertainty regarding US political dynamics. Historically, these events are short-term in nature and stability returns to the markets as long as corporations continue to make money. Of course, the situation requires close monitoring, something we routinely do in all market conditions. Whichever investment decisions we decide upon, fear and panic should not be part of the equation.
***Premium members may want to review our Emergency Management Report located in the “resources/downloads” section of your member site.
This week’s economic news of importance:
- Existing home sales Feb 5.54 million (above expectations)
- Weekly jobless claims 3/17 229,000 (above expectations)
- Markit manufacturing PMI March 55.7 (expansion)
- Markit services PMI March 54.1 (expansion)
- Leading indicators Feb 0.6% (previous 0.8%)
- Durable goods Feb 3.1% (above expectations)
- New home sales Feb 618,000 (below expectations)
THE WEEK AHEAD
Mon March 26th
- Chicago Fed national activity index Feb
Tue March 27th
- Case-Shiller home price index Jan
- Consumer confidence index March
Wed March 28th
- GDP Q4
- Pending home sales Feb
Thu March 29th
- Weekly jobless claims through 3/24
- Personal income Feb
- Consumer spending Feb
- Consumer sentiment index March
Fri March 30th
For the week, the S&P 500 declined by 5.95% for a year-to-date return of (-) 3.19%%
IBD: Uptrend under pressure
GMI: 2/6- Buy signal since market close of February 20, 2018 (approaching sell signal)
BCI: Moving to all in-the-money strikes. Currently fully invested and rolling down to out-of-the-money strikes when opportunities arise. Will re-adjust when the market settles.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bearish outlook. In the past six months, the S&P 500 was up 1% while the VIX (24.87) moved up by140%. Historically, the VIX and S&P 500 are inversely related.
Wishing you much success,
Alan and the BCI team