A reverse stock split is an action taken by a corporation to boost the price of its stock. For example, in a one-for-two reverse split, 200 shares of a $4 stock are replaced by 100 shares trading for $8 each. Investors end up with fewer shares that sport higher prices. Reverse stock splits aren't considered positive events, because they highlight the fact that a stock price has fallen to a very low level.
Reasons for a Reverse Split
Corporations initiate reverse splits for several reasons, among them respectability. Companies with low stock prices are often regarded with derision by investors and analysts. A low price raises the specter of bankruptcy and liquidation – not a winning profile for a company. By raising the stock price through a reverse split, a company is looking to increase interest in the stock. It also may raise the stock price above the minimum required for margin investing – usually $5 per share. Margin investing involves borrowing part of a stock’s purchase price from a broker.
Reevaluating Your Position
In light of a reverse split, it makes sense to re-examine the stock and verify that it is still worth holding. Your original analysis may have predicted a rise in the stock price, but the reverse split usually indicates that stock prices have fallen. You also want to ascertain the company’s credit risk to determine if it can it pay its debt or if it's suffered a credit rating downgrade. A high debt-to-equity ratio may be a red flag that signals an inability to make interest payments. If earnings are down or sales margins have dropped, it may be time to unload your shares.
Option One: Sell the Stock
If you reevaluate the stock and find it wanting, you can simply sell the stock and invest your money in a safer company. If you feel the stock is a real loser, you can take more aggressive steps, such as shorting the stock or buying put options – both of these strategies profit from stock price declines. Shorting involves selling borrowed shares and repurchasing them later at a lower price. Put options give you the right to sell the shares at a price that may be above the future market price.
Option Two: Stand Pat
If you're undecided about the stock, you can wait for further clarity before taking action. If your opinion is slightly negative, you can sell covered calls against the shares. Each call you sell may obligate you to deliver 100 shares of your stock for the stated strike price. In return, you keep the premium paid by the call buyer for the option. Your benefit from instant income, which can cushion a stock price decline, but you give up any gains should the stock move above the strike price.
Option Three: Buy More
You may conclude that the reverse split is part of a winning strategy that will boost the long-term value of the stock. Buying more shares is an affirmation that you feel the company is sound and won't be undergoing bankruptcy. If a competitor company reaches the same conclusion, it may attempt a takeover, which will cause your stock to rise sharply.
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