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Reverse Stock Splits and How they Effect our Option Contracts

In a filing with the SEC last week, Citigroup said it is considering a reverse stock split as part of its effort to convert preferred shares (take priority over common shares on earnings and assets in the event of liquidation) to common shares.

What is a reverse stock split?:

It is a reduction in the number of a corporation’s outstanding shares and a corresponding increase in the value of those shares. For example, if you own 200 shares of company XYZ @ $5 per share, a 1-for2 reverse stock split would result in your owning 100 shares @ $10 per share. The value of your holding remains the same:

200 x $5 = $1000

100 x $10 = $1000

Reasons why reverse stock splits are done:

1-It makes corporate shares look more valuable although there has been absolutely no change in real worth.

2- Many institutional investors have rules against purchasing a stock whose price is below a certain minimum level, $5 perhaps. Citigroup now falls into that category.

3- Fear of being delisted is another possible reason. If a stock falls below a certain price, it may no longer meet the exchange requirements and face delisting or being removed from trading rights on that particular exchange.

4- Reduce the number of shareholders is a rare but possible explanation for a reverse split. If the split results in a shareholder owning less than a minimum required number of shares, they would receive a cash payment and no shares of stock. This may be benficial to a company seeking to be put in a different regulatory category such as an S-Corp which is required to have less than 100 shareholders.

Typically, a stock will temporarily add a “D” to the end of its ticker symbol during a reverse stock split.

Citigroup situation:

Let’s take a look at a chart of Citigroup as of 3-24-09:

You can see that Citigroup went from a $50 per share stock to a $3 per share equity. To get this to a somewhat cosmetically acceptable scenario, a 1-for-10 split would be necessary. This would elevate the share price to $30 per share. If you owned 1000 shares @ $3 before the split, you would own 100 shares @ $30 after the split. 

What does a reverse split signal? :

In 2008, Jim Rosenfeld, an associate professor of finance at Emory University’s Goizueta Business School in Atlanta, did a study involving 1600 companies that did reverse stock splits. He found that the typical stock in his study underperformed the market by 50% on a risk-adjusted basis during the three year period after the action. His conclusion:

“Reverse stock splits are a strong indicator the company is going to be a significant underperformer during the near future.”

What if I sold covered call options on such a stock? :

Perhaps you were out partying the night before and had a bit too much to drink. You woke up the next morning and omitted your first cup of high-octane coffee that might have brought you out of your fog. Through no fault of your own, this drug-induced state causes you to ignore all the fundamental and technical requirements of our system. Common sense is also tossed out the window as you rationalize that Citigroup cannot possibly go any lower than $30!  Okay, that’s all water under the bridge. Here’s an example that is simple to follow:

  • You sold 10 contracts of the $5 call.
  • After a 1-for-10 split that would change to having sold 1 contract of the $50 call.
  • Ticker symbols would change but the expiration date remains the same as does the premium initially collected.

When the numbers don’t break down as perfectly as these, it is much more complicated. The best way to handle these scenarios is to contact your broker or the CBOE Exchange. The split information can be obtained online as follows:

www.cboe.com/contractadjustments

You can also call the CBOE (Chicago Board Options Exchange) for free information:

1-888-678-4667

For more information on conventional stock splits, here is a link to an article I published a year ago:

 /blog/stock-splits-and-their-effect-on-our-option-contracts/

I also devoted a full chapter in my book, Cashing in on Covered Calls, to the subject of stock splits.

* The Blue Collar System will force you to avoid all stocks that are forced to resort to reverse splits. They simply will never meet our fundamental and technical criteria.

 Industry in the Spotlight:

Great performing stocks can oftentimes be located by first identifying those industries that have been favorites of the institutional investors. One such group in the Chemical Manufacturing-Fertilizer Group. Here is a chart showing a definite reversal of a downtrend for the last several months:

Chemical Manufacturing-Fertilizer Industry 3-09

Chemical Manufacturing-Fertilizer Industry 3-09

Three stocks that are performing well within this industry are TRA, SQM and CF. Check them out and see if they belong on your watchlist.

 

Last weks economic news:

The final revision of the 4th quarter 2008 GDP was down 6.3%, the worst since 1982. However, there was good news on the economic front last week. February exisitng home sales rose 5.1% from January and new home sales were up 4.7%. Consumer spending was up for the second straight month along with an increase in prices, allaying fears of deflation. February durable goods orders were also up for the first time in seven months. For the week, the S&P 500 was up 6.1% for a year-to-date return of – 9.0%.

My best to all,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

17 Responses to “Reverse Stock Splits and How they Effect our Option Contracts”

  1. admin March 29, 2009 10:19 am #

    Email Suggestion from Lou:

    Dear Alan,

    You express some difficulties in the treatment of tax accounting in reporting options to the IRS. May I suggest a program that I have been using for the last three years by the name of TRADE LOG. Reasonable and accurate records, including wash sales.
    Best wishes,
    Lou

  2. admin March 29, 2009 10:23 am #

    Lou,

    Thanks for sharing your experiences and ideas.

    We are also working on an enhancement and expansion of the ESOC (Ellman System Options Calculator) to include tax accounting capabilities.

    Alan

  3. admin March 31, 2009 4:18 am #

    Monday was a bleak day for the markets fueled in part by rumors about possible Chapter 11 bankruptcy filings for struggling Chrysler and GM, that could threaten the government’s plan to create or save 3.5 million jobs.

    This does not mean that all stocks or industries were down. Take for example, the “schools industry”, a group that has been highlighted for the past few months on this site. Some of our favorites from this industry had a positive up-day yesterday. Check out ESI, APOL and APEI.

    Alan (back home and getting to all your emails)

  4. admin March 31, 2009 5:40 pm #

    NTES chart pattern:

    In the beginning of March the chart pattern of NTES was telling us something….buy this stock! At the end of February this company had a favorable ER and the market responded positively. Those who watched the chart pattern after that noticed the following:

    1- Positive crossover of the exponential moving averages
    2- MACD burst through the centerline and remained positive
    3- The stochastic oscillator moved up crossing over the important 20% line and continued north
    4- Investors were rewarded with a price increase from $20 to $27 in 1 month

    Although there are never any guarantees, a favorable technical picture like this one throws the odds in our favor for a successful result. Since ther ER just passed, there won’t be another one for 3 months that could mess things up.

    Many times I will sell an I-T-M strike after a run up like this, expecting some profit-taking that may cause a temporary downturn in share price.

    Alan

  5. admin April 1, 2009 8:27 am #

    Oh those earnings reports…..

    Why do I stress avoiding ERs? They create volatility and risk. Even a great ER that falls short of street expectations can kill a stock’s price.

    Take a look at what happened to APOL today. This has been a great performer in a great industry. BCIs who avoided this one because of the ER are feeling like Albert Einstein today.

    Alan

  6. admin April 2, 2009 11:54 am #

    With only 2 weeks remaining until expiration Friday, we know that time value of option premiums will begin to decay precipitously. That doesn’t mean that there are no interesting deals out there. Take, for example, BWLD currently selling for $36.85. If we took a conservative approach and sold the April $35 call, here are the calculations:

    Buy 100 x BWLD @ $36.85

    Sell 1 x BQU-DG @ b$2.55

    ROO= 255 – 185 /3500 = 2% 2-week return = 52% annualized.

    Dowside Protection = 185/3685 = 5%

    This means that we are guaranteed a 2% 2-week return as long as our shares do not decline by more than 5% in the next 2 weeks. It will take a full year to get that return from a CD.

    Alan

  7. Steve P April 2, 2009 11:57 am #

    Alan,

    Can you explain what a positive moving average crossover is. You mentioned it in the comment #4 above.

    Thank you

    Steve

  8. admin April 2, 2009 12:33 pm #

    Steve,

    Two of the technical indicators we look at when evaluating an equity are the 20-d ema and the 100-d ema. Ideally, we would like to see the shorter term ema above the longer term ema (the 20 above the 100). This shows a positive momentum. When the 20-d ema is BELOW the 100d ema but the crosses over ABOVE the 100-d ema, that is a positive technical moment especially if it occurs on high volume. Although this is only one part of the puzzle, it is a significant one and always peaks my interest in that stock. This is what I meant by a positive moving average crossover.

    Alan

  9. admin April 3, 2009 2:10 am #

    SGP has recently caught my attention due to its strong fundamentals. Review the stock checkup page and you’ll see that its ranks first in its industry in every category and the Scouter Rating is “9”.

    The chart shows an uptrending stock with positive moving average indicators. There is a red flag in that the MACD and Stochastic oscillator recently turned negative. This will usually guide me to an I-T-M strike if I decide to write a cc on this equity.

    There are unusual strike prices for this stock. These are oftentimes due to mergers and acquisitions. Our choices would be the I-T-M $22.50 or the O-T-M $24.

    $22.50 Strike:

    ROO = 145 – 120/2250 = 1.1% 2-week return = 29% annualized.

    Downside Protection = 120/2370 = 5%

    This means that we are guaranteed a 1.1% 2-week return as long as the share price does not decrease in value by more than 5% in the next 2 weeks.

    $24 Strike Price:

    ROO = 55/2370 = 2.3% 2-week return = 60% annualized.

    Upside Potential = 30/2370 = 1.3% with no downside protection. Although a 1.3% return doesn’t sound exciting, remember that it will take 6 months to get that return from a CD…only 2-weeks here.

    Alan

  10. Robert G April 3, 2009 8:18 am #

    Alan,

    I heard the term “protective puts” used with covered call writing. Could you explain how this works and if you recommend using them.

    Thanks
    Bob

  11. admin April 3, 2009 8:28 am #

    Bob,

    Look at a protective put like you are purchasing an insurance policy against a dramatic drop in your stock price. A put is the opposite of a call option…it gives you the right to sell your shares at the specified strike price.

    For example, if you bought a stock for $38 and sold the $40 call, you may buy a protective put @ $35. No matter how far below $35 your share price drops, you can sell for $35.

    The reason I do not use protective puts (but have no problem if others do) is because of the very nature of my system, its safety and the use of exit strategies.

    I have been receiving several email questions of this nature so I plan to write a more detailed article about this topic within the next few weeks.

    Alan

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  14. Brad January 21, 2014 3:15 pm #

    Hello Alan, I would first like to think you for your work. It has been very enlightening. I have a small amount of money $2,000.00 and I also think that the stock market in two years will have a 10%-20% correction. The QID etf inversely follows the qqq index, and the options are very affordable at the time being.They will be reverse splitting this Friday (January, 23, 2014), and I was wondering if the stock option priec will also go up ruining my chance to maximize my profits seeign as I can not buy odd lot options in smaller amounts than 100. Should I buy them now or just wait until the reverse split options fall in price again? Thank you for your time,

    Most sincerely Brad

    • Alan Ellman January 21, 2014 4:40 pm #

      Hi Brad,

      Before I get to your question I want to point out that this is a very risky trade. Although the options premiums are low, it’s still your hard-earned money. If you have accepted the high risk then okay but I want to be sure you are aware of it and made that informed decision. QID will generate 2x the daily inverse returns of QQQ which has been on fire for quite a while. That means that QID has been a “dog”

      If your assessment is correct, in 2 years you will generate 2x 10-20% of some figure which may be a figure a lot higher than now, which means QID may continue to deteriorate before (if) the correction. There is a reason here for the reverse split. Check it out.

      Anyway, as far as premium is concerned, the time value depends on the underlying security which doesn’t change, the time to expiration which doesn’t change and the implied volatility which may change but not because of the split. So, all things being equal the premiums shouldn’t be impacted much.

      Your decision isn’t so much when the trade should be made but if the trade should be made and only you can make that decsion based on your personal risk tolerance and overall market assessment.

      Alan

  15. Brad January 21, 2014 4:52 pm #

    Hello Alan,

    Thank you very much for your timely and lengthy answer. I just want to make sure I am clear on a few things. QID January call option is currently priced @ 2.01 per option thus I could purchase 10 lots for a price of $2,010.00. If the cost of the options increased 4 times too, than I could only afford 2 lots for a total cost of $1,608.00. Is this how things work with a reverse split? because if it did, then my leverage would be drastically decreased. Does the volatility of the pre split stock option significantly diminish post underling issue stock split? Thank you again, you are great.

    Brad O.

    • Alan Ellman January 21, 2014 6:05 pm #

      Brad,

      Your leverage will not be impacted by the split. The Options Clearing Corporation makes sure that buyers and sellers of calls and puts are “made whole” after the split. No free lunch either way. The options purchased before the split will only deliver 25 shares after the split. New options will deliver the standard 100 shares. Even though you will pay more for the new contracts, from a % standpoint there will be no difference. If your plan is to buy long-term options on this security, pre and post-split makes no difference.

      Alan

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