Is the Citi Stock Split Bad for Options?

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CitiGroup (NYSE: C)

Options trading investors have made Citigroup Inc. (NYSE: C) one of the most actively traded classes for exchange-listed options. But things will soon change as Citi has announced a 1-for-10 reverse stock split. That means that for every 10 shares an investor owns she will get one share at 10 times the share’s value when the reverse split takes place.

The stock trades around $5 now and presumably will trade around $50 after the split. Citi has announced the reverse will become effective after the close on Friday, May 6.

So, what does this mean for option traders? At its simplest level, there will be some cosmetic but not fundamental changes on the options a trader already has in inventory. But it may have some farther-reaching implications.

Commentators have wondered whether total options volume will decrease because Citi’s option volume is based in part on its cheap price. Taking it further, if there are fewer Citi traders does that mean the options market will take a hit?

I don’t buy the drop in volume argument. In fact I think it will probably be just the opposite. In my opinion the Citigroup reverse stock split will provide several benefits to traders, increase trading efficiency and increase the total value of the options market.

How the Split May Impact Trading

In options lingo, the notional value of Citi will remain the same after the split. The notional value refers to the monetary value of the shares that can be controlled by an option.

To trade the same notional value, traders will only have to trade one “new” Citigroup option instead of 10.  Let’s look at the numbers:

Current C     — 10 options = 1000 shares @ $5  =  $5,000

New C          —   1 option    =   100 shares @ $50 = $5,000.

So traders will reduce their trading in C options, causing a decline in its volume and in total options volume, because Citi strikes are always very active.

Go to page 2 for more of Dan Pasarelli’s analysis.

Source: iStock

Citi Reverse Split

But it is unlikely that the decline will be significant. For starters, in the short term the C reverse split should mean an increase in volume as arbitrageurs trade “old Citi” versus “new Citi” looking to exploit market imperfections.

Secondly, the options market is large, diverse and adaptable.  Traders, investors, speculators, all the players move on. The entire auto market doesn’t decline because Toyota has supply chain problems due to the recent disasters in Japan. Car buyers look elsewhere. Toyota modifies its production process.

Consider the pricing/volume argument by looking at two very popular options products — the SPDR S&P 500 ETF (NYSE: SPY) and the S&P 500 Index Options (CBOE: SPX). Both names represent the S&P 500. But the value of the SPY is one-tenth the value of the SPX, currently about $130 versus $1,300. Still, both products are giants in options volume and the larger SPX has often been an option volume leader.

Granted, Citi is a single equity and is very different from the S&P 500, but the comparison shows that there is a market demand both for lower-priced assets and for premium-quality trading vehicles (pardon the pun). In fact the volume in SPX is very high regardless of its nominal price tag.

Volume aside, the reverse split ought to be good for traders. If, indeed, a trader is only trading one option instead of 10 to control the same amount of stock, he will pay one-tenth the commission per transaction. Gotta like that. Also, the “bid-ask transaction cost” is likely to be reduced as well.

The Bid-Ask Transaction Cost

When traders make a trade, they effectively pay a transaction fee to the market because they generally must buy at a higher price than they are able to sell at any given moment. We’re talking about the bid-ask spread. If right now, near-the-money options are, say a penny wide (which they typically are in Citi), traders have an effective transaction cost of 10 cents on every 10-lot. Why? Because the price at which traders can buy the 10 contracts is always a penny higher than the price at which they can sell them. Whether traders make or lose money, that cost is always there, either reducing would-be profits, or adding to actual loses.

But after the split that 10-cent cost won’t necessarily be built into the near-the-money Citi options. They are likely to have a tighter bid-ask spread – it might only be two or three cents wide. So, traders won’t pay 10 cents to trade the same notional value that a pre-split 10 lot would give them; they should be paying less. Indeed, this reduction could benefit traders by lowering transaction costs.

Why Citigroup Has Active Options

To really understand the impact of the impending split, traders need to ask themselves: why are Citi and Citi options so heavily traded? Is it just because they are cheap? I’d say no. It’s because Citigroup has been, and continues to be, a significant company in the U.S. equity landscape.

There may be a minority of traders who trade Citigroup stock because it is nominally cheap. But buying a stock just because you can afford it is not a good investment strategy.

Frankly, these traders are what I’d call “riff raff”. They are traders who don’t help in the price discovery process because they don’t trade based on value — only on price. In general, this trader doesn’t add much value to the market — only noise.

Please go to page 3 for more of Dan’s analysis.

Citi Reverse Split

A higher-priced Citigroup should eliminate some of the riff raff and return the stock to more efficient pricing. This may mean fewer contracts traded, but option holders would control a greater value of Citi stock, thereby increasing notional value.

How the Split Will Impact Options – Nuts & Bolts

Right now, if a trader exercised a C June $5 Call, he’d pay $500 and get 100 shares at $5 a share. If a trader waits until after the split, he or she will still have a $5 call, but its exercise implications will change.

Here’s how it works — let’s assume the reverse occurs and Citi is trading at $50.  If a trader exercises a 5 strike call, he will still pay $500 for the stock, but he will get only 10 shares of stock. That’s because the call still gives the right to purchase $500 of Citi stock, or 10 shares at $50.

After the split, there will be new Citigroup options listed that will trade in addition to the “old” Citigroup options. The new options will be standard where the exerciser of a call option receives 100 shares of Citi at the traded strike price. The strike prices for the new Citigroup will probably be 40s, 45s, and 50s while the “old” Citigroup options – the 4s, 4.5s, 5s, etc – will still exist.

When you call up the Citi option chain you will see something different with a new symbol. There will be the “C” options which will probably be used for the new strikes and there will also be an offshoot, like “C1”, that will be used for the “old” strikes. That new symbol should be announced as we get closer to the reverse split.

Conclusion

The Citigroup reverse stock split will lower traders’ costs, tighten markets, increase market efficiency and should increase the notional value traded in the options market. All in all, the reverse split in the stock should be good for option traders.

Dan Passarelli is the founder and CEO of MarketTaker.com, the leader in options education. Dan has more than 17 years’ experience in the options industry as a market maker, Options Institute instructor and author of “Trading Option Greeks.”


Article printed from InvestorPlace Media, https://investorplace.com/2011/04/is-the-citi-stock-split-bad-for-options-c/.

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