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What a Stock Split Really Means to You
So you just heard that a company whose stock you own, or one you might be interested in owning, will soon split its stock. Is this a meaningful event that you should pay attention to, or something that you probably can ignore?
The answer likely lies somewhere in between. In fact, stock splits – and their opposite cousins, the reverse stock split – can mean a lot or a little.
“The devil is in the details,” said Brian Bachelier, vice president of active trader strategy at Scottrade. “But you certainly shouldn’t ignore splits. In subtle ways, they can make a difference to investors and perhaps provide some insight into a company.”
The Meaning of a Split
On paper, stocks splits are a wash to investors. A company whose stock was worth $500 million before a split, will be worth $500 million after it. The only difference is that there will be more shares available at a lower price. A 2 for 1 stock split, for example, means that the price will be cut in half.
A reverse stock split does the opposite. A 1 for 2 split means that there will be half as many shares available, but the price will double.
Why You Should Care
So if a stock split doesn’t affect the value of stock, why should you care? There can be practical and psychological reasons.
- Portfolio management. In general, smaller-priced securities can give you greater ability to manage your portfolio. Let’s say you have 10 shares of a stock selling for $50 a share, but want to reduce your exposure by 20%. You can do that by selling 2 shares. But if that same stock was $250 per share, and you owned just 2 shares, it would be impossible to reduce your exposure by anything less than 50%.
- Psychological considerations. Be careful when you’re evaluating a company that splits its stock, which results in a lower stock price. Psychologically, you might be prone to believe that a stock selling for $100 a share is overvalued, while the same stock now selling for $25 might be undervalued because the price is so much lower.
- Option trading. A split reduces the upfront cost and capital requirements traders need to have in their accounts post-split to create new covered call and cash-secured put positions.* (For an explanation of how splits affect existing options, read the section below.
- Listing requirements. The stock exchanges typically have rules on the price of stocks. If the price falls too low, the exchanges can delist a stock. Some companies address that by increasing their price through a reverse stock split. A reverse stock split also can make a security more attractive to investors who don’t feel comfortable trading low-priced stocks.
“You can’t predict the movement of a stock based on its price alone,” Bachelier said. “A $500 stock could be a bargain, while a $15 stock might be way overpriced.”
A covered call is a strategy where the trader must own the stock and then sell a call against the stock to receive a cash premium. The trader’s intent is to profit if the underlying stock price rises or stays flat. However, the trader risks a loss if the value of the stock drops further than the premium received from the option. With a cash-secured put, the trader collects a cash premium in exchange for the obligation to buy the underlying stock if the price falls. A trader needs to have enough cash in his account to buy the stock at the contract’s strike price. If the stock price remains flat or moves higher, the trader retains the premium at expiration. In both cases, the trader can lose up to the value of the cash or stock, minus any premiums received.
“Investors should look closely at companies using a reverse stock split,” Bachelier said. “This could be a sign of a troubled company whose stock price has fallen dramatically.”
How Splits Affect Existing Options
In cases where the number of new shares is easily divisible by 100 (whole split), the Options Clearing Corporation (OCC) will adjust the option strike price downward using a divisor. However, to keep the value of your option position perfectly balanced, the number of contracts you hold will be adjusted by an appropriate multiplier.
Example (7-to-1 Split):
Stock Split Bottom Line
Investors and traders should keep in mind that a stock split doesn’t change the fundamental elements of a company, Bachelier said. “A split, by itself, isn’t a buying or selling opportunity,” he said. “You should use the same trading and investing tactics with a company involved in a stock split as you would with any other company.”
*Assumes a non-adjusted option is being used to create the new position.
Question: Has a stock you owned gone through a split? Tell us about it in the Comment section below.
The information and content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Scottrade Options Application and Agreement, Brokerage Account Agreement, by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by requesting a copy from your local branch office. Supporting documentation for any claims will be supplied upon request. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies. Keep in mind, profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.
The covered call option strategy may help generate income and offer limited downside protection, but does not provide full downside protection and may limit profit potential.
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