Splitting Alphabet May Be A Boon To Options Traders

By:

Chief Strategist at Interactive Brokers

By now you almost assuredly know that Alphabet (GOOG, GOOGL) reported excellent earnings shortly after US markets closed yesterday and the stock rose accordingly.  But the more market-moving news had nothing to do with the company’s fundamentals – it was the announcement of a 20:1 stock split effective on July 18th

Let’s be clear – stock splits have no bearing on a corporation’s business or balance sheet.  They are the equivalent of making change.  You give me a $20 bill and I give you back 20 singles.  There are differences in utility to having different denominations of currency – one person may prefer to have singles for small purchases or tips, while another may prefer to have a thinner wallet – but the amount of each person’s wealth is unchanged after a transaction of that sort.  In this case, if you own 100 shares of GOOGL valued at $3,000 each at the close of July 15th, you’ll have 2,000 shares of GOOGL valued at $150 each on the open of July 18th.  Either way, they’re worth $300,000. 

Markets believe that the utility of a lower share price exceeds that of a higher one.  A phrase we’ve heard many times today is that the split will make the stock more accessible to individual investors.  That was certainly the case when stocks traded almost exclusively in round lots of 100 shares each.  But that hasn’t been the case for quite some time.  The concept of odd-lot vs. round lot has largely vanished over the years.  Furthermore, the advent of fractional share trading largely removed any barriers to entry for those who want to get exposure to the stocks of even the most expensive companies.  That assertion is appealing, but not necessarily accurate in the current market environment.

That said, options on Alphabet are likely to become far more accessible to individual traders.  When a stock splits, the Options Clearing Corporation adjusts the options prices to reflect the split.  If you own 1 contract of the 3,000 strike calls expiring in September on July 15th, you’ll have 20 contracts of the 150 strike calls on July 18th.  All things being equal, the price of those options will be 5% of what they were pre-split.  This has a profound effect on the affordability of options.  The smallest available increment of options is one contract that reflects 100 shares of the underlying stock.  As I type this, the GOOGL 3,000 calls expiring on Feb. 18th are about $66 per contract.  One contract would therefore cost about $6,600.  If the split were miraculously to occur right now, the resulting 150 strike calls would be priced at roughly $3.30 per contract.  That means that the minimum outlay for that call would be $330. 

With a minimum cost of entry that will be 1/20th of what it is currently, the options will indeed be more accessible to small traders.  Even better, spreads should decline markedly.  The current spread on the 3,000 strike options discussed above is $1.50.  Simple math would imply that the spread would shrink to 7.5 cents, but I would not be surprised to see the spread to a nickel or less.  If the options are more accessible to smaller traders, it would imply that liquidity would improve.  More liquid markets tend to have narrower spreads.  For example, options in Apple (AAPL) with a similar relative price and time to expiration have spreads between 1 and 5 cents. 

I’m not certain why the company is choosing to wait until after July expiration to effect its stock split, but I wonder if options weren’t a factor there as well.  Bear in mind that there are 2 classes of stock, all with multiple strikes, some with intervals as small as $5.  Those $5 intervals will become 25 cents, which far below a normal strike space.  It wouldn’t surprise me if we see exchanges ratchet back the number of available strikes in order to minimize the ensuing quote traffic that could result from 2 sets of options with strikes in quarter-dollar increments.  While that might be a temporary inconvenience to traders, the benefits of smaller contract prices and tighter spread should more than compensate for that inconvenience.

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