Even though we are programmed to believe the title of this article is simply clickbait, I can assure it is anything but.
Traders have been misinformed for far too long.
Traders make a major mistake about an opportunity to double your money – at half the price.
Luckily, you’re not going to make this mistake…
Because I’m going to give you the facts right now.
Follow the Stock Split
Often times financial pundits gloss over stock splits.
They seem to foster the idea that the value of your holdings doesn’t increase following a stock split and it basically stays the same.
But stock splits can be much more exciting than simply getting 2 for 1.
Many times, for different reasons, after a stock split the underlying stock has an odd tendency to go back to its pre-split price.
It doesn’t happen overnight, and it can take a year or more… but it happens.
And as a good investor, doubling your money in a year is a pretty good profit target.
And when a stock that has split, goes back to its original price, it has DOUBLED!
So what exactly happens with a stock split.
First, we need to know that all stocks traded publicly have a set number of shares outstanding. A stock split is when the board of directors of the company decides to increase the outstanding shares by giving away more shares to its current shareholders. There is absolutely no additional value added to the stock when this happens, it just means that one share turns into two shares and that makes the price per share lower than before the split.
Seems simple enough to follow right?
It is not different than asking for two $10 bills in exchange for a $20.
A stock split works pretty much the same way. Instead of having one bill worth $20, you now have two bills that together total $20.
Stock splits are usually a sign of a company’s health, and it is usually a good sign. A split can happen when a company is looking to attract a new group of investors by lowering the share price.
A reverse split works the exact opposite way and is usually a bad sign for a company’s health. Many times a company performs a reverse split to avoid being delisted.
Stock splits (and reverse stock splits) are typically reflected in ratios. Here are some common stock split ratios you may have seen:
2:1 (2-for-1): You’ll end up with two shares of stock for the price of one share
3:1 (3-for-1): You’ll end up with three shares of stock for the price of one share
3:2 (3-for-2): You’ll end up with three shares of stock for the price of two shares
And here are some common reverse stock split ratios:
1:2 (1-for-2): You’ll end up with one share of stock for the price of two shares
1:5 (1-for-5): You’ll end up with one share of stock for the price of five shares
1:10 (1-for-10): You’ll end up with one share of stock for the price of ten shares
And when the stock splits, the options split…
Here is a good example provided by Tom Gentile of Money Map Press
Before a company goes through a stock split, there’s always the possibility that current shareholders will buy more stock. People who don’t own the stock may see an opportunity to buy the stock before the stock split happens.
After the stock splits, people may buy the stock because they can afford it at its post-split price, which is less than it was before to stock split happened.
But you know that I’m a short-term options trader, and my goal is find money doublers within 30 to 45 days.
So I’m not looking to buy-and-hold stock or buy LEAPs.
If you’re unfamiliar with LEAPs, these are long-term options that have expiration dates of up to three years in the future.
And the buying volume before and after a stock split could fuel even more buying, leading to a potential rally in a higher price.
So how do you participate in and profit off of a stock split?
You guessed it… buy call options.
When a stock declares a split, the options will remain the same until the date the split is to take place. On that date, your option in most cases will split too, just like the stock, so rest assured you won’t be losing anything.
Now, there are some instances when the option prices remained normal, but that’s rare. You should consult with your broker on specific cases. (In addition, note that the option symbols will more than likely change as well).
Let’s look at an example to get a better understanding of how stock splits can double the value of your options portfolio. We used The Walt Disney Company (NYSE: DIS) as our example on Tuesday, so we’ll use it again…
Say that it’s Thursday, and DIS is going to do a 2:1 split next Wednesday. The stock is trading at $100 and you’re considering buying one contract (100 shares) on a $100 call option for $4.00.
Investors would pay $10,000 to own 100 shares of the $100. But as an options trader, you’re only spending $400 to get 100 shares.
Fast forward to Wednesday, the day of the split, and the stock drops down to $50. Our investor friends are now sitting at $50 on 200 shares of DIS, and still have $10,000 worth of the stock – just as they did before the split.
But when the stock splits, so does the option….
And what this means for you here is that the strike price for your call option is now split in half. So instead of having one $100 call option contract, you now have two $50 call option contracts.
Furthermore, that $4.00 premium on the $100 call option contract also gets split in half, dropping that premium down to $2.00
The end result?
You now have two contracts of the $50 calls on DIS at a basis of $2.00 (the same $400 cost risk as before the split).
But remember… more buying often happens before and after a stock split. After all, why would you pay $100 for one share of DIS if you can get it at $50 per share after the split?
So let’s say that the buying volume continues to increase, driving that price back to $100. Because of the stock split, you now have two $50 call options for a total premium of $4.00, with the stock trading at $100… giving you a double.
And if that the price doesn’t reach $100?
The cool thing about options is that the stock price may not even need to double in order for the options to double. It can be just slight enough in the short term that the options still hit a double.
This is why leveraging the power of options on a company that splits it stock could prove lucrative for you… with minimal risk.
Here’s Your Trading Lesson Summary
You may have heard that stock splits do not change the value of your portfolio. But you can leverage the power of options to double the value of your positions after a stock split. Here are four basic things to know:
A stock split is when the number of outstanding stock shares are increased
A reverse stock split is when the number of outstanding stock shares are decreased
A stock split can be a good sign for a traders and investors
A reverse stock split can be a bad sign for traders and investors
— The Option Specialist