Synthetic Short Stock (Split Strikes) Explained

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Stock Split

What Is a Stock Split?

A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because the split does not add any real value. The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares, respectively, for every share held earlier.

Key Takeaways

  • A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares.
  • Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because the split does not add any real value.
  • The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares, respectively, for every share held earlier.
  • Reverse stock splits are the opposite transaction, where a company divides, instead of multiplies, the number of shares that stockholders own, raising the market price accordingly.

Understanding Stock Splits

How a Stock Split Works

A stock split is a corporate action in which a company divides its existing shares into multiple shares. Basically, companies choose to split their shares so they can lower the trading price of their stock to a range deemed comfortable by most investors and increase liquidity of the shares. Human psychology being what it is, most investors are more comfortable purchasing, say, 100 shares of $10 stock as opposed to 10 shares of $100 stock. Thus, when a company’s share price has risen substantially, most public firms will end up declaring a stock split at some point to reduce the price to a more popular trading price. Although the number of shares outstanding increases during a stock split, the total dollar value of the shares remains the same compared to pre-split amounts, because the split does not add any real value.

When a stock split is implemented, the price of shares adjusts automatically in the markets. A company’s board of directors makes the decision to split the stock into any number of ways. For example, a stock split may be 2-for-1, 3-for-1, 5-for-1, 10-for-1, 100-for-1, etc. A 3-for-1 stock split means that for every one share held by an investor, there will now be three. In other words, the number of outstanding shares in the market will triple. On the other hand, the price per share after the 3-for-1 stock split will be reduced by dividing the price by 3. This way, the company’s overall value, measured by the market capitalization, would remain the same.

Market capitalization is calculated by multiplying the total number of shares outstanding by the price per share. For example, assume that XYZ Corp. has 20 million shares outstanding and the shares are trading at $100. Its market cap will be 20 million shares x $100 = $2 billion. Let’s say the company’s board of directors decides to split the stock 2-for-1. Right after the split takes effect, the number of shares outstanding would double to 40 million, while the share price would be halved to $50, leaving the market cap unchanged at 40 million shares x $50 = $2 billion.

Important

In the UK, a stock split is referred to as a scrip issue, bonus issue, capitalization issue, or free issue.

Reasons for a Stock Split

Why do companies go through the hassle and expense of a stock split? For a couple of very good reasons. First, a split is usually undertaken when the stock price is quite high, making it pricey for investors to acquire a standard board lot of 100 shares. For example, Apple Inc. issued a 7-for-1 stock split in 2020 after its share price had climbed to almost $700 per share. The board of directors figured that the price was too high for the average retail investor and implemented the stock split to make the shares more accessible to a wider set of potential shareholders. The stock price closed at $645 the day before the split was activated. At market open, Apple’s shares were trading at approximately $92, the adjusted price after the 7-for-1 stock split.

Second, the higher number of shares outstanding can result in greater liquidity for the stock, which facilitates trading and may narrow the bid-ask spread. Increasing the liquidity of a stock makes trading in the stock easier for buyers and sellers. Liquidity provides a high degree of flexibility in which investors can buy and sell shares in the company without making too great an impact on the share price.

While a split in theory should have no effect on a stock’s price, it often results in renewed investor interest, which can have a positive impact on the stock price. While this effect can be temporary, the fact remains that stock splits by blue chip companies are a great way for the average investor to accumulate an increasing number of shares in these companies. Many of the best companies routinely exceed the price level at which they had previously split their stock, causing them to undergo a stock split yet again. Walmart, for instance, has split its shares as many as 11 times on a 2-for-1 basis from the time it went public in October 1970 to March 1999. An investor who had 100 shares at Walmart’s initial public offering (IPO) would have seen that little stake grow to 204,800 shares over the next 30 years.

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Example of a Stock Split

In June 2020, Apple Inc. (NASDAQ: AAPL) split its shares 7-for-1 to make it more accessible to a larger number of investors. Right before the split, each share was trading at $645.57. After the split, the price per share at market open was $92.70, which is approximately 645.57 ÷ 7. Existing shareholders were also given six additional shares for each share owned, so an investor who owned 1,000 shares of AAPL pre-split would have 7,000 shares post-split. Apple’s outstanding shares increased from 861 million to 6 billion shares, however, the market cap remained largely unchanged at $556 billion. The day after the stock split, the price had increased to a high of $95.05 to reflect the increased demand from the lower stock price.

Reverse Stock Splits

A traditional stock split is also known as a forward stock split. A reverse stock split is the opposite of a forward stock split. A company that issues a reverse stock split decreases the number of its outstanding shares and increases the share price. Like a forward stock split, the market value of the company after a reverse stock split would remain the same. A company that takes this corporate action might do so if its share price had decreased to a level at which it runs the risk of being delisted from an exchange for not meeting the minimum price required to be listed. A company might also reverse split its stock to make it more appealing to investors who may perceive it as more valuable if it had a higher stock price.

A reverse/forward stock split is a special stock split strategy used by companies to eliminate shareholders that hold fewer than a certain number of shares of that company’s stock. A reverse/forward stock split uses a reverse stock split followed by a forward stock split. The reverse split reduces the overall number of shares a shareholder owns, causing some shareholders who hold less than the minimum required by the split to be cashed out. The forward stock split increases the overall number of shares a shareholder owns.

Does using a synthetic short futures split strike position in trading options involve margin money ?

Wiki User
March 14, 2020 7:12AM

No. It involves a great deal of courage and knowledge of the market’s direction, though.

This strategy involves selling slightly out-of-the-money calls, and buying an equal number of slightly out-of-the-money puts on the same underlying futures.

Example: Acme is trading at 30. You think it’s going to trade at 7 next month. So, you sell a call at 35, and buy a put at 25. We will say the premium on both ends of this is the same, which keeps us from having to calculate premiums into the losses and gains.

If Acme trades at 28 next month, or 32 or any number between $24.95 and $35.05, both options expire worthless.

If Acme trades at 20 next month, the call will expire worthless and the put will net you $5 per share. Options are written against 100 stocks, so you pick up $500. (If it really did drop to 7, you’d make a lot of money.)

The problem is, Acme might trade at 50 next month. If you blow it that badly, it will cost you $5000 ($50 x 100 shares) to pay off the call.

Margin is buying stocks on credit, and you couldn’t use it to pay off that call.

Fun fact: this system of buying puts and selling calls is how the Madoff ponzi scheme was billed as working.

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