When it comes to options, there are two common questions that I am usually asked: the first is how a stock split — or a reverse split/consolidation — impacts the terms of an options contract; and the other relates to the cash settlement of index options.

Regarding the first question, the simple answer is that anything affecting the number of shares outstanding in the underlying security does not alter the economics of a derivatives contract.

For example, suppose you own XYZ Co.’s April 100 calls, with XYZ trading at $103.50 a share. These April calls grant you the right to buy XYZ at $100 a share until the third Friday in April.

Suppose that XYZ’s management decides to split the stock by a factor of three (i.e., a three-for-one stock split). At current levels, the post-split stock price would be $34.50 ($103.50 divided by 3 = $34.50). An April option to buy XYZ at $100 a share would be worthless under those conditions.

In order to protect the interests of the options trader, the options contract will also split along the same lines as the stock. In this case, instead of owning one XYZ April 100 call, you would end up with three XYZ April 33.33 calls, each exercisable for 100 shares of XYZ.

Whether three-for-one or four-for-one, stock splits work the same way. As long as the numerator is one, you end up with more option contracts, a different strike price and the same underlying multiplier.

Other split factors are more complicated. For example, what happens if XYZ were to split its shares on a three-for-two basis? Although this is not typical, there have been situations in which an odd split factor was used. At one time, for example, when Cisco Systems Inc. was a high-flying stock, management made liberal use of the three-for-two split model.

Regardless, the result is the same, although the calculation is a bit more complicated. In a three-for-two split, you end up with the same number of options contracts, but the strike price of the option and the number of shares that the option is exercisable into change.

If XYZ were to split three for two, you would end up with one XYZ April call with a strike price of $66.67 ($100 strike price multiplied by two and then divided by three = $66.67). In this case, the call would be exercisable into 150 shares rather than the standard 100-share underlying multiple. At this stage, you have the right to buy 150 shares of XYZ at $66.67 a share — which, from an economic perspective, is the same as having the right to buy 100 shares at $100 a share.

As mentioned earlier, the cash settlement of index options is another common question that I am asked. The appeal of index options is the decision process attached to a specific trade — which is to say, there is only one question: is the market going up or down? There is no need to worry about specific sectors or stocks within specific sectors. Removing sectoral and company-specific risk presumably means fewer pitfalls — and greater potential.

Having said that, there are risks unique to index options that traders should understand. Most notably, the risk inherent in cash-settled U.S.-style options.

Virtually all index options are settled in cash, which is very different from physi-cal delivery, in which you are required to either buy or deliver the underlying shares based on the particular exercise notice.

Cash settlement simply means that an exercise or assignment results in the delivery or payment of cash representing the difference between the strike price and the current value of the underlying index.

For example, assume you were long a hypothetical ABC April 640 cash-settled index call option. For the purposes of this example, suppose ABC closed on a Monday night at 664. After the close of trading, you decide to exercise your ABC April 640 call. In this example, you would receive the difference between the strike price of the call ($640) and the closing value ($664) of the index, times the underlying multiplier (100). Specifically, ($664 less $640 strike price = $24) x 100 = $2,400 cash per contract (not accounting for applicable commissions). The $2,400 typically would be credited to your trading account on the next business day — in this case, Tuesday.

@page_break@Cash settlement is obviously convenient. But for traders who like trading index option spreads, cash settlement creates some unique risks. A spread involves the purchase and sale of call or put options with different strike prices, or similar strike prices and different expiration dates. The objective with all spreads is to establish a position in which the return potential and risk is limited.

Suppose you were holding a bear call spread in which you sold an ABC April 640 call at $20 and, to limit upside risk, purchased an ABC April 660 call at $11. The initial position was taken on with a net credit of $9 a share, or $900 per spread.

The most you can lose on this position is $20 ($2,000 per spread), which is the difference between the two strike prices ($660 – $640 = 20). And because you received a $9 credit when setting up the position, your real risk is only $11 ($1,100 per spread), which is the difference in strike prices less the net credit received.

But what happens to the limited-risk argument, if you were on the other side of the exercise notice used in the previous example (ABC closes at $664 on the Monday)? Recall that you receive the assignment notice Tuesday morning, and your account is debited Tuesday evening. Settlement value is based on Monday’s closing index value.

If you want to exercise your long ABC April 660 call to close out your position, you will receive a settlement value based on the closing index value Monday night — with only a remote chance that the index will close at exactly the same price on Tuesday night.

As exercising the long ABC April 660 call is not a reasonable alternative, you are left with the sometimes frustrating task of trying to sell that call option after the market has opened — and that could take some time. The opening rotation for index options can take as long as 20 minutes to complete, and by that time, the market could have moved significantly. IE