Stock splits are corporate events where the number of shares in circulation changes as well as the price -per-share. If we own 100 shares at $50.00 per share pre-split and the stock splits 2-for-1, then we will own 200 shares at $25.00 post-split. The value of our position ($5000.00) does not change.
What is a reverse stock split?
This is a reduction in the number of corporate shares along with a corresponding increase in share value. In the above example, a 1-for-2 reverse stock split would result in owning 50 shares at $100.00 per share, still a $5000.00 total value.
Why would a company promote a reverse stock split?
There are several reasons this would make sense, none of which would encourage us to own the stock or exchange-traded fund (ETF).
- From a cosmetic standpoint, the increase in stock price makes the company appear more formidable and successful
- Certain exchanges require a minimum price or the stock can be de-listed
- Institutional investors tend to avoid lower priced securities
Real life example: UVXY
The chart below tells us everything we need to know why this ETF twice opted for a reverse stock split:
On July 12, 2016, as share value has plummeted to $7.00 per share UVXY announced a 1-for-5 reverse stock split. The effective date for this split was 7/25/2016. Share price on the 25th was about $6.00 per share so for every 100 shares owned pre-split, 20 shares at $30.00 would be the new position post-split. The position value does not change at the time of the split but $30.00 is more cosmetically pleasing than is $6.00.
How does a reverse split impact our options?
There is no one formula that will apply to every scenario so we must research these contract adjustments. Here are related free resources:
- Ask your broker to research for you (the first two are better choices in my view)
Let’s view the changes in this specific example:
UVXY changes to UVXY2
Shares deliverable per contract
100 shares become 20 shares
UVXY2 = 0.20 (UVXY) or 1/5 the market price
Multiplier (amount option price changes in total value for a 1.00 change)
The multiplier remains 100 so if option price changes by “1” total contract value changes by $100.00
In addition to the newly adjusted contracts (UVXY2), the exchanges begin introducing non-adjusted contracts based on the new market pricing. This creates a scenario wherein some contracts deliver 100 shares while others deliver 20 shares (I’m even getting a headache from this… however, in the interest of education we push on.
Unreliable option chains
When adjusted contracts exist along with standard contracts (100 deliverable), there should be some sort of indication as to which is which. In this case, adding that “2” to contract symbols with an explanatory footnote would do the trick. However, that’s not always the case. In the screenshot below, the options chain shows a $3.00 strike trading between $2.88 – $3.25 for a stock trading at $21.74. For standard contracts, that is impossible as there is at least $18.74 in intrinsic value. That’s how we know that this is an adjusted contract.
Further down this very same options chain, we see a non-adjusted $20.00 contract with a bid-ask spread we would expect for a stock price $1.74 in-the-money and expiration coming up in a few hours:
Reverse stock splits are generally corporate maneuvers designed to give the appearance of safe, secure and reliable investments. These events will result in contract adjustments for our options and these changes do not always fit one specific formula. It is important to understand the implications of these changes and to carefully view options chains that may not discern between adjusted and non-adjusted contracts. Asking ourselves if the premium amount makes sense for a standard contract will get us to the correct understanding of the contract type.
For more information on stock splits:
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Global stocks declined slightly this week while US indices remained flat. The Dow Jones Industrial Average approached the psychologically significant 20,000 mark before consolidating. Crude oil lost about 75 cents on the week, ending around $52.50, while the Chicago Board Options Exchange Volatility Index (VIX) remains historically low, at 11.44. This week’s reports and international news of importance:
- Already strong US gross domestic product figures were revised higher in the final reading for the third quarter. Originally reported at 3.3%, the economy actually grew 3.5%, according to an estimate by the US Bureau of Economic Analysis
- Q4 growth looks to be somewhat less impressive with estimates in the 2.0% to 2.5% range
- In the United Kingdom, Q3 growth was also revised higher. On a quarter-over-quarter basis, the UK economy expanded 0.6% in the three months following the Brexit vote, up from an earlier 0.5% estimate
- Italy’s government has authorized a bailout of that country’s third-largest lender, Monte dei Paschi di Siena, after the bank failed to raise sufficient capital in the financial markets to stay afloat. Monte dei Paschi has been in operation since 1742
- If the United Kingdom does not remain a member of the European Union’s single market, Scotland will hold another referendum on withdrawing from it, according to Scottish first minister Nicola Sturgeon
- The Bank of Japan upgraded its economic assessment, noting that a moderate recovery trend had continued while exports had picked up. Improved foreign demand was credited with the export boost, along with a weaker yen, which should help solidify the recovery, the bank said
- Deutsche Bank and Credit Suisse each agreed to settle outstanding cases with the US Department of Justice involving the selling of mortgage-backed securities dating back to the global financial crisis
THE WEEK AHEAD
- Japan releases consumer price and unemployment data on Monday, December 26th
- Japan reports retail sales data on Wednesday, December 28th
- US November pending home sales figures are released on Wednesday, December 28th
For the week, the S&P 500 declined by 0.07% for a year-to-date return of +10.47%.
IBD: Market in confirmed uptrend
GMI: 5/6- Buy signal since market close of November 10, 2016
BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 6% while the VIX (11.44) declined by 35%.
Wishing you the best in investing and a wonderful holiday season,
Alan (firstname.lastname@example.org) and the BCI team