Welcome to Splitsville
Vol #93: August 12th, 2022
Over the course of the past year Elon Musk has sold over $32 billion dollars worth of Tesla stock, yet at the end of this month he’ll hold more shares than he ever has.
This is not some quirk of executive comp where he’s earning more than he’s selling. Though he does have a sweet pay package, allowing him to pick up $23 billion worth of shares earlier this year as part of a multi-year incentive package.
While his ownership percentage has dipped - now under 15% - he will own more Tesla shares because the stock is planned to split once again. After a 5:1 split in 2020, Tesla will split on August 25th, giving each shareholder two additional shares of Tesla.
This 3:1 split is mostly just an accounting gimmick. The nominal value of the company hasn’t changed, no new capital has been raised and there’s no dilutive effect. A single unit of ownership is simply worth a third as much as it was before, and there are three times as many.
Stock splits are mostly about the dollar price of a single share of stock. They make a single share more accessible to investors, which also makes a round lot of 100 shares more accessible. That’s important for options traders, and options volumes, particularly at the retail end of the spectrum.
Companies like Berkshire Hathaway have long eschewed the idea of splitting their stock. Their A class share now trades around $445,000. Fidelity’s massive Contrafund - the largest actively managed mutual fund holding $97 billion of assets - only needs to hold 18,936 shares to get $8.5B of exposure.
Owning a round lot of Berkshire Hathaway Class A shares ($45M) is prohibitive for almost any individual or even medium sized institutions looking for diversification. (Options are only listed on the B shares anyways.) With TSLA trading at $870, an $87,000 minimum position to effectively manage equity with options strategies is also prohibitive to a significant class of traders.
Options are a great way for institutions and individuals alike to manage their exposure to an underlying. Whether you want to write calls against your upside and collect the rich volatility premium in Tesla, or perhaps use that to finance put protection against the next inevitable drawdown, it’s not financially possible unless you own the full 100 shares. With the price of entry for these strategies dropping to a third of their current level, it opens up opportunities for many new investors.
There is some folklore that a stock split will cause the price to jump. To the extent that new smaller investors come in, that marginal demand should increase the price. That said, there’s enough ebb and flow on a daily basis - especially in a name like Tesla - that any predictability is lost.
Fractional shares have become popular in the last few years as brokerages and clearing companies have developed accounting and trading operations to facilitate partial ownership. For portfolios with smaller balances, that feature is helpful in managing rebalances more precisely and reduces tracking error on a given index or benchmark. That reduces some of the demand for splits, but it doesn’t solve the options question.
If a stock split will open up opportunities for new investors, what happens to the current investors who are holding options positions?
The OCC manages the process for contract deliverables, strike adjustments, and generally any options adjustment that come from a corporate action like a stock split, merger, rights offering, or special dividend. You can read the full details of the Tesla split here, but the jist is that it’s a standard 3:1 split. There are a few moving parts: the strikes adjust to ⅓ their value, the deliverable stays the same, and the contract multiplier is 3x.
If you have a covered call position in TSLA, where you’re long 100 shares of stock and short 1x of the 900 call, the following will happen on August 25th. You will now own 300 shares of stock that will in theory open at ⅓ of the price it previously closed at, plus or minus whatever Musk tweets on Wednesday night. 100 shares at $870 becomes 300 at $290.
Similarly, the strikes of the options adjust according to the split ratio. The $900 call now becomes the $300 call. Each option strike on the board has a published adjustment ratio, rounded to 2 decimal places. The $875 strike becomes the $291.67, and the $880 becomes $293.33.
Your short call option was the obligation to sell 100 shares of TSLA at $900 if the buyer exercised the contract (i.e. spot closes over $900, or they choose to exercise early). The contract deliverable stays the same at 100 shares - this is what allows new investors after the split to buy one contract representing 100 shares of the 66% cheaper stock price.
To rectify this, there is a contract multiplier of 3, which means your short 1 x $900 call, becomes short 3 x $300 call, still hedging your now long 300 shares of stock. Economically you are indifferent to this, if TSLA rose from $870 to $900, you would make $30 per share plus whatever the call sold for. Now, you’ll make $10 on the rise from $290 to $300, but on 3x as many shares.
There are some quirks and externalities from these splits. The main impact is to volumes, you can probably expect TSLAs trading volume to triple plus some. The “plus some” comes from investors who were unable to trade options before due to the notional size of a round lot.
That’s good for brokers who are collecting per contract payment for order flow, and it’s good for exchanges who charge per contract trading fees. It’s not good for investors who are paying per contract to execute or exercise.
Particularly astute observers might notice the rounding that takes place on a 3:1 split. With 2:1 splits the strikes round cleanly, but ⅓ is a repeating decimal. If I own one unit of the $10 / $15 call spread, the most that could be worth is $500 (difference in strikes times the deliverable). After the split, I will now be long 3x of the $3.33 calls, and short 3x of the $5 calls. The most that spread could be worth is now technically $501 ($5-$3.33)*(100)*(3).
The practical limits of arbitrage make this a moot point. This is only true of the terminal value of the options, so to take advantage of this you’d need to find something very deep in the money to buy it for $5 to make that “guaranteed” penny. If you buy something any closer to the money, that’s no different than buying a 95 delta call spread for $4.95 and hoping it closes to $5. This is something you can do on any stock, and as options synthetics tell us, it’s effectively the same as selling the put spread for $0.05, or “picking up nickels in front of a steamroller.”
If you find that deep in the money spread, it’s also likely you’re going to have to pay more than $5 anyways. Dealers quote these markets wide because they’re delta intensive options. Anyone who’s tried to close down in money spreads for max value will tell you how many pennies they give away.
Large institutions and dealers with significant options exposure at the time of the split will have a somewhat random position relative to strike rounding. It would be unrealistic to price strikes with exposure to split rounding differently and somehow take this into account. Not only is the occurrence of a split unpredictable, but a ratio of 5 looks different than 4, 3, or 2. Ultimately if one penny of edge difference on a massive call spread is going to have a big impact on your PnL, you probably have too much exposure on.
There’s a lot of mechanics and accounting that has to go on behind the scenes with stock splits, but thanks to clean and transparent processes from a centralized clearing organization, it’s a pretty vanilla process for most investors. The lack of arbitrage and economic indifference of most actors means that it’s a well functioning process, with some net upside by opening up opportunities to smaller investors.