Recently on April 23, 2021, we witnessed the sixth reverse split that VXX – the iPath® Series Short Term VIX Futures ETN – has undergone since its inception in 2009.
If you’re unfamiliar with what VXX is or how it works, I made a video explaining it here. I recommend watching it first before reading this article.
Calculating what happens to a share position when a stock or exchange-traded product undergoes a split (or reverse split) is straightforward and taken care of automatically by your broker.
In a 4:1 split, the issuer desires a lower share price. If an individual owns 1 share at $40, their new position will be 4 shares at $10. In a 1:4 reverse split, like what VXX undergoes, the issuer desires a higher share price. If an individual owns 4 shares at $10, their position will now be 1 share at $40. Stock splits result in zero change in the value of the position held.
Odd lots are usually paid out in cash to avoid fractional shares. In a 1:4 reverse split, an individual who owns 26 pre-split shares at $10 will likely receive 6 shares at $40 plus $20.00 cash.
But what will happen to an option position?
Option clearing houses like the OCC in the United States or the CDCC in Canada don’t want to deal with the logistics of splitting option contracts. Instead, they simply change the deliverable – the number of new post-split shares to be exchanged (if, of course, the option expires in the money).
This means the premium, or price of the option itself does not change because the value of the deliverable underlying shares will remain the same.
A 1:4 reverse split like our example above results in the standardized deliverable of 100 shares being changed to 25. An option with a deliverable of 25 shares at $40 should be worth exactly the same as an option with a deliverable of 100 shares at $10, all else remaining equal.
How does this play out in practice?
I took a screenshot of my VXX position before and after the reverse split had taken effect:
A temporary underlying, VXX1 in this case, is created for option holders where the deliverable is changed from 100 to only 25 post-split shares.
Unlike our example, this event didn’t occur in a vacuum so the open P&L changed as the underlying VXX continued to move. However, it is normal for the pricing displayed by your broker to be inaccurate during the first few hours of trading following the split. For this reason, it never hurts to simply close out your position the day before the reverse split.
As a best practice, you might also wish to wait at least a week or so after any split before trading the new options. This will allow some time for market participants such as market makers to begin creating some volume.
Watch out for declining liquidity in the old options.
The 25/100 deliverable contracts will continue to exist for VXX1 until they expire. However, you should exit your position and move over to the new 100/100 contracts as soon as possible. The liquidity in the 25/100 contracts will gradually drop off. Volume and open interest will decrease, bid/ask spreads will widen and eventually, they will become functionally untradeable.
Let’s compare option chain data from ThinkorSwim for 100/100 and 25/100 deliverables for the same expiration:
While the average spreads and open interest can be deceiving at first, the dead giveaway is the volume. The 25/100 expiration cycle sees only a tiny fraction compared to the 100/100.
Why still so much open interest? It’s hard to say for certain and fairly irrelevent for our purposes. My guess is institutional traders with hedging strategies, or market makers letting their contracts wither on the vine and expire.
It doesn’t matter though, because no volume = no liquidity. There’s no reason not to begin trading the new 100/100 deliverable.