How many ways can you slice a pie?
We’re looking at another alternative investment, options on stock splits and the analogy is fitting. If you have a whole pie and split it 12 ways, you’ve still got a whole pie, right?
In the case of stock splits, it’s the same general principle – no more value is added as the overall “pie size” is still the same. This being said, there are many investors who take advantage of stock splits to do better than the average market portfolio.
How do they work and how can you make money from them? Let’s take a look:
What are options on stock splits?
First of all, it’s worth taking a look at what a stock split actually means.
Let’s say I own 10 shares in a company at $50 per share. My total holding is $500 worth of shares. The company then decides to split their shares on a 2:1 ratio (they could use a different ratio if they chose), this means that the number of shares I own doubles to 20, while the value of each share halves to $25. The overall value remains the same – companies can never create any more value by splitting their stock.
Why do companies choose to split their stock? It typically happens when their stock is starting to look expensive and they want to keep attracting casual investors. If their stock is $50 per share and most competitors are at $20, the company seeks to prevent casual investors from assuming that the competing shares are better valued (which of course, is not necessarily true).
It may be a question of accessibility too. When Apple Inc. announced a 7:1 stock split in 2014, its shares were trading at about $645 a share immediately prior to the split. Apple CEO Tim Cook said, “We are taking this action to make Apple stock more accessible to a larger number of investors.”
[bctt tweet=”Perception and liquidity of trading are the two key reasons for a stock split.” username=”susanlyons”]
From this sense, it is usually a good sign if a company is splitting their stock because it usually denotes a bullish market, or the company anticipating that their shares will continue to rise. On the other hand, a reverse split works the opposite way. The 10 $50 shares would become 5 $100 shares. Historically, this tends to happen when a company wants their stocks to look more valuable and often indicates that you should be skeptical about the prospects of the company.
Options and splits
So, what happens if you own options on stock that has just declared a split? Your options undergo an adjustment too. Instead of covering 10 shares as in our example, you now cover 20 shares.
The same thing happens with your strike price. Let’s say you had a $60 strike price on those 10 shares, you now have $30 over 20 shares.
How do you make money?
If a stock split doesn’t add value, how exactly do you make money on owning options? This is where we look at the historic data on stock splits to see if there’s any real benefit.
According to an article in Bottom Line, there is evidence to show that stock that has split on the 2:1 ratio has done better over time. Neil MacNeale, an experienced investor who has been very successful with making money from 2:1 splits has seen his returns over time do vastly better than average.
“Macneale has capitalized on a powerful side effect of stock splits. Stocks that split two-for-one tend to beat the broad market by more than three percentage points annually, on average, for the two to three years after the announcement of the split.”
Macneale describes a split as a reliable sign that management of the company has confidence that it will continue to flourish and that the stock price will likely keep rising. The stock is also given momentum by investors piling in at the time of the split, assuming the cheaper price will attract more investors and pushing up the price as a result.
Here’s Macneale’s strategy:
“To take advantage of this momentum, I maintain a 30-stock portfolio, and around the middle of each month, I purchase one new stock of a company that has announced a split within the past three to seven weeks, regardless of when the actual split takes place. At the same time, I sell off my oldest position. This ensures that each stock remains in the portfolio for 30 months, the sweet spot for performance according to stock-split studies.”
If you trade in options, you can take advantage of the same overall growth trends on 2:1 splits. Let’s say the stock splits while you already own call options. Your calls are split by the same ratio. Using the original example, let’s say you owned one call option for 100 shares with a strike price of $52. When the 2:1 split occurs, you now have 2 call options (100 shares each) with a strike price of $26.
If overall trends hold true, your strike price will probably be met and you will become the owner of 200 shares that are (hopefully!) on an upward price trend.
From another view, you could also do well with options by following a strategy similar to Macneale’s for purchasing shares. Buy call options on stock that has recently split and you can make money when your strike price is met and the value of the underlying asset continues to rise.
There are plenty who will argue that a stock split really has no effect, which in theory, is correct. The overall value is not changed. However, the advantage seen is that a stock split is a good buying indicator. Companies who are trending downward don’t want to split stocks and risk looking like a penny stock. It’s the bullish tendency that we’ve seen over time with portfolios such as Neil Macneale’s which lend credence to the idea of profiting from a split.
For you as an investor, it might be the opportunity you were looking for to be able to invest in a high-performing company. Going back to the Apple example, if you couldn’t pay $645 per share prior to the 7:1 split, it might move the share price to a range that is acceptable for you.
What are the risks?
The risks of this strategy are really the same as any other stock-purchasing or options trading strategy. The bottom line is that you may end up holding stock that is worth less than you paid for it.
A good point to note from Macneale’s strategy is that when he purchases a new stock, he always uses a purchase amount of 3.33% of the total current value of his portfolio. It’s a strategy to avoid a “too many eggs in one basket” scenario. You might choose a different ratio, but it’s always a good idea to help mitigate risk by setting limits for yourself.
Another thing to pay attention to is the reverse split. If you own options or stock already in that particular company, it is often not a good sign. Reverse splits are often an indicator of low-priced, high-risk stocks or some kind of trouble within the company.
On the whole, before investing in any stock or options, you should do your research on the company. You’re looking for a healthy balance sheet and overall positive indicators, although of course, as with any investing, there is always the chance of the unexpected happening.
There are also funds out there which are specifically set up to take advantage of stock splits if you’d prefer to leave the decision up to a manager. An example is TOFR, a stock split index fund.
Overall, it’s not the stock split itself that can be profitable – the whole value remains the same as immediately prior to the split. The key with splits is that they can be an indicator for overall high performance.
Stock becomes more liquid as more casual investors find the price attractive and trends show that two for one split stock has a history of performing better as compared to the average market.
It’s about getting in on the stock of high-performing companies and hopefully making a gain as the value of the underlying asset rises.