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. Where does that $4.50 come from?
The rounded up money comes from issuing new shares. A reverse stock split affects the total number of shares first by combining shares, then by adding a few new ones when rounding up fractional shares.
Let’s use an example: say a company undergoes a reverse stock split with a ratio of 1 to 6. For every six shares, there will now be one share. If the company had 1,000,000 shares before the split, they would now have 1,000,000 divided by 6, or 166,667 shares after. But they must also round up fractional shares. Say there were 1000 shareholders holding random numbers of shares. Each would get between 0 and 5/6 of a share after the split. To round up everyone who needs it, the company will need to create about 417 shares.
The total value of the company is spread out over the 166,667 shares plus the extra 417. To cover the extra 417 shares, the share price should theoretically go down about by about 0.25%, i.e. 417 / (166,667 + 417) = 0.25%. That’s the dilution.
So who pays for those fractional shares? The other shareholders do, in the form of an extremely small reduction in share price.
How Much Do Single Share Reverse Split Round Ups Dilute?
If everyone who followed the Reverse Split Arbitrage Twitter account buy a single share of a stock that was about to perform a reverse split, how much would it dilute the stock?
This varies by the number of investors, the company’s market capitalization, and the ratio of the reverses split. But let’s use an example of the a recent reverse stock split of Moleculin Biotech (MBRX) on February 1, 2021. The ratio of the split was 1 to 6, the market cap was $60m and the Reverse Split Arbitrage Twitter account had 2500 followers. If each follower buys a single share, then rounding up creates 5/6 of a share x 2500 investors = 2083 shares.
MBRX has about 12 million shares (market cap divided by share price). Dilution can be calculated by dividing the number of created shares by total shares. In the case of MBRX, reverse split arbitrage would dilute the stock by a mere 0.0017%. This is hardly enough to move the price.
But How Can I Profit Off Reverse 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 at the same broker, as that just means you’ll get rounded up less. You can, however, purchase a single share at multiple brokers and let them all round up. There are at least 15 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.