Understanding Option Pricing: Why All Out-Of-The-Money Options Do Not Trade in Fractional Increments

Many traders and investors wonder why out-of-the-money options do not trade in fractional increments. This article aims to clarify the reasoning behind this practice, leveraging real-world examples and industry insights.

Why Option Prices Do Not Extend to a Third Digit

When you see a quoted option price with a single decimal, such as "0.65," it actually represents a price per one share of the underlying stock. For instance, if an option costs $0.65, this means the premium for a single share is $0.65, but the option contract typically covers 100 shares. Therefore, the actual price is 100 times the quoted amount—$65 per contract.

Here's the key point: option quotes always extend to the nearest full dollar amount. This means that any fractional value is rounded to the nearest whole number. For example:

0.64 is equivalent to 64 cents 0.65 is equivalent to 65 cents 0.66 is equivalent to 66 cents

The Importance of Avoiding Arbitrage Opportunities

Even for out-of-the-money options, trading in fractional increments creates potential arbitrage opportunities. In finance, arbitrage refers to the practice of taking advantage of a price difference between two or more markets. By using fractional increments, arbitrageurs could exploit this discrepancy, leading to potential losses for the exchange or the market.

Must Read: What is Arbitrage?

The Impact of Stock Splits on Option Strikes

Another crucial aspect to consider is the impact of stock splits on option strikes. When a stock undergoes a split, the strike prices of options also adjust accordingly. For example, if a company with a 45 strike call or put option subsequently splits its stock 2 for 1, the strike price becomes 22.50. Consequently, an option contract would need to be adjusted so that the new strike price of 22.50 aligns with the market. This ensures that the option pricing remains fair and consistent.

Stocks can split in various ratios, such as 3 for 1 or 5 for 1. When this happens, the strikes become even more complex. For instance, if a stock undergoes a 5 for 1 split, the original 45 strike would become 9. This complexity ensures that options remain liquid and fair for all participants.

Simplifying Calculations

Is it really too difficult to multiply the fractional value by 100? Not at all! Here's an example:

Suppose the quoted option is at $0.43. This means:

$0.43 per share × 100 shares per contract $43 per contract

For a 0.19 quoted option:

$0.19 per share × 100 shares per contract $19 per contract

Such effortless calculations help traders and investors make informed decisions quickly and efficiently.

Additional Reading: Understanding Stock Splits

Conclusion

In summary, the practice of trading option prices in full dollar increments, even for out-of-the-money options, is a strategic choice to avoid arbitrage opportunities and ensure fairness in the market. The impact of stock splits on option strikes highlights the ongoing need for consistent and transparent pricing adjustments. While it might seem inconvenient to multiply the fractional values by 100, the benefits of a fair and efficient market structure outweigh the simplicity of decimal calculations.