In a reverse split, shares are consolidated at a specified ratio, say 10 to 1. In that case, every ten shares would be worth one share. Because the value of the company hasn’t changed, the new shares are worth theoretically 10 times as much as the old shares. There are a few reasons companies might do a reverse split, but it’s normally a way to increase share price to meet minimum listing requirements for major exchanges.
Options in a reverse stock split
Options are handled in a similar way. An option is a contract that allows a one to buy or sell stock at a future date (called the expiration date) at a set price (called the strike price). Options have strange names: the right to sell a stock is a put, and the right to buy a stock is a call. Confused yet? An option contract gives you the right to buy or sell not one share but 100 shares, called a round lot. Want more? You can also sell calls and puts. When you own the underlying 100 shares, it’s called a covered call or put. When you don’t own the shares, it’s called naked. This is how you get the phrase “hedge funds sold naked calls on Gamestop at $200 strike price and a 3/19 expiry” and people just nod. Don’t play with options unless you want to sound like this at parties.
When a stock undergoes a reverse split, the options are automatically adjusted to maintain their prices. This adjustment is sometimes called “being made whole.” An option that controlled 100 shares would be adjusted down based on the reverse split ratio. An option whose stock underwent a 1:10 reverse split, for example, would control 10 shares. For a 1:5 reverse split, it would control 20 shares.
The strike price is also adjusted, but adjusted up to match the new theoretical share price. A strike price of $1 where the common stock undergoes a 1:10 reverse split would be adjusted to $10. For a 1:5 reverse split, it would be adjusted to $5. Expiration date remains the same.
Can I make money off Reverse Splits Using Options?
Not really. Options prices are adjusted to reflect the underlying stock. Penny stocks that undergo reverse splits often see a drop in price as investors have more liquidity and can exit their long positions, but these stocks often don’t have tradeable options, nor are they shortable. Even if they were, they occasionally spike, are vulnerable to pump-and-dump schemes, and are quite risky.
Can I make money off Reverse Splits in other ways?
There is one way to consistently profit off reverse stock splits. Say a company performs a reverse stock split at a ratio of 1 to 10. If you had bought 1 share before the split for $0.50, after the split you’d have 1/10 of a share, a fraction which historically could not be traded. To get around fractional shares, companies will sometimes pay the cash value of the fractional share, in this case $0.50. Other times, though, they will round you up to one full share. When they round up, the share you had bought for $0.50 is now worth around $5. You profit $4.50 at minimal at risk.
It’s nice, clean profit, but $4.50 is too small to get excited about. You can’t buy more shares in the same account, as that just means you’ll get rounded up less. You can, however, purchase a single share in multiple accounts at multiple brokers and let them all round up. There are at least 16 brokers that round up fractional shares from reverse splits.
If you’re interested in trading reverse splits that round up, subscribe to my newsletter and Twitter to get notified of upcoming splits the day they happen. Make sure your broker is one that rounds up fractional shares (some don’t round up as policy, while others charge fees). A running list of participating brokers can be found here along with sign up links to get you free stocks. If you’re interested in recent successful trades, they are posted here. More information about trading reverse splits can be found on the homepage here.