Trading Software and Books Reviews

Contract Sizes and Strike Prices

When writing both put and call options over shares it’s important to check the underlying contract size before placing your order with your broker. Too often an option writer will automatically assume that one option contract in Australia is equal to 1,000 underlying shares.

It can be a very frustrating exercise to buy shares in multiples of 1,000 in order to write covered call options, only to find that you can’t write the required call option contracts due to the fact that you don’t own enough shares to perform the exercise.

One reminder to check the underlying contract size will usually be the fact the option contract exercise or strike prices are at odd numbers. This will usually mean that the company has undergone a capital return or bonus or entitlement issue to shareholders and the current option contracts are adjusted to protect the exercise value of the options that are in existence before and after the entitlement has expired.

So how does the option contracts become odd contract sizes with odd strike prices then?

Well let’s look at the current options for Telstra Limited. Telstra’s option exercise prices are at odd price numbers. For example Telstra is trading at $4.70 and the two nearest strike prices for both the near dated put and call options are $4.72 and $4.47. In other words the strike prices are now all 3c lower per share.

If we now check the contract size we can see that the underlying contract size for Telstra has been adjusted to 1007 shares per option contract. So we need to own 1007 shares in Telstra in order to write one covered call option contract.

It’s the same if we wanted to write put options over Telstra in order to purchase the shares at a discount to the current market price. We now need to lodge the collateral or margin to purchase 1,007 shares instead of 1,000 shares.

The reason for this adjustment is that Telstra paid out a special 3c bonus dividend to shareholders on the 17th of March 2003. Therefore when the announcement was made and the ex-dividend date was declared, the call options that were in existence after that date would normally fall by 3c per share and the put option premiums would normally rise by 3c a share, as it was taken into consideration that the underlying stock would naturally fall by the dividend amount on the ex-date.

So to keep the options market orderly, the ASX applies the following formula for such incidents.

The contract size is adjusted by taking the current contract size and adding it to the special dividend per share divided by the volume weighted average price of the stock on the last day of cum-dividend trading, minus the special dividend amount.

Now that the option contract size has been adjusted, the option exercise prices must also be adjusted too.

So the formula here is to multiply the current strike or exercise price by the old contract size divided by the new contract size.

Once the stock goes ex-special dividend, the new contract size and strike prices take effect. Once those options expire, the contract size and strike prices revert back to normal on the new options.

Glen Van Ooran

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