Covered Call Writing And Non-Standard Options

Includes: DIA, QQQ, SPY
by: Alan Ellman

Checking option chains is standard operating procedure for covered call writers and options traders in general. From time to time, we will see an oddball strike price or similar strikes with different premiums in the same month for the same underlying security. We have entered the world of non-standard options.

What are non-standard [NS] options? :

These are options that don't have the standard terms of an options contract, namely 100 shares as the underlying asset. They are normally created as a result of a specific event, such as a merger, acquisition, spin-off, extraordinary dividend or stock split. As a result of the changing circumstances, the contract is adjusted to be equitable to both the option buyer and seller by equating the new underlying asset(s) of equal value as the owner of 100 shares. The Depository Trust Company [DTC] determines how the shares will trade pre-event, while the Options Clearing Corp. [OCC] decides how these changes will be reflected in the options.

Each situation is unique and therefore non-standard. This makes them difficult to understand, and therefore risky to most investors. In the above hypothetical example, one contract was a standard options contract, the other non-standard. The standard contract represents 100 shares of the underlying, while the NS contract does not. As an example, when Bank of America (NYSE:BAC) took over Merill Lynch, the owner of 100 shares of Merill received 85 shares of BAC stock plus $13.71 in cash. NS contracts of BAC now would deliver 85 shares of BAC + the cash, as opposed to the standard contracts, which represented 100 shares. The obvious rule is avoid all non-standard options. Let me add another: if an option value seems too good to be true, it is. These contracts will also show odd strike prices and different root symbols.

Real life options chain for BAC showing standard and NS options(note the original options symbology):

Options Chain with NS Options

I have highlighted the two $5 strike options. BYO DE is the standard option, which represents 100 shares of BAC, while JLW DA is the non-standard, representing 85 shares of BAC + cash. An uninformed investor looking to buy an option would think the NS option is a much better deal, costing $179 per contract, as opposed to $254 per contract. The caveat is that the former will deliver only 85 shares (+ cash), not 100 shares.

Liquidity of NS Options:

These contracts are often illiquid and difficult to trade. In this chart, we can see the volume of the standard contract is 3990 compared to the 209 for the NS contract. When evaluating the liquidity based on open interest, one can easily be deceived, as many of those option holders had their contracts since prior to the merger. Most likely there has been little activity in them since.

Timing of contract adjustments:

When contract adjustment is needed as a result of the aforementioned events, the standard ("plain vanilla") options are adjusted accordingly. When a new option comes into existence after the event, it will appear as a standard option. ****Check with your brokerage company to make sure that you will be notified, prior to execution, if attempting to trade a NS option.

One time cash dividends and adjusted strike prices: From time to time, we will notice options chains with oddball (non-standard) strike prices resulting from one-time cash dividend distribution. For a strike price to be changed as a result of a dividend, two criteria must be met:

  • It must be a one-time only distribution
  • The dividend must be for more than 12 1/2 cents.

In 2010, Guess (NYSE:GES) declared such a dividend, this one for $2. It went ex-dividend on December 6th, and that is when we saw the option strike prices reflect this dividend. Here is a chart showing the strikes before and after:

Once again, if an option value seems too good to be true, it is.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.