Stock Splits Explained
Dear Rich Lifer,
Once you have experience trading stocks, you get used to the ebb and flow of the markets.
You’ve probably added options to your lineup. You’ve done the research, read the articles, and attended the seminars. You feel confident.
But then, one of the biggest companies in the world — Apple (AAPL) — announces a 4-for-1 stock split, its fifth split since going public in 1980, and you happen to hold an options position.
If you’re scrambling to figure out what happens now, today you are in luck.
We will cover what it means for outstanding stock and options positions.
Everything you need to know about what this means for you and your investments will be covered below…
What Is a Stock Split?
Take any amount of stock and double it, or triple the number of shares—you could even go wild and multiply it times 10. That’s essentially what happens when a company splits its shares.
You have more shares than you had before, but are you actually richer or otherwise better off? The short answer: Not on the surface.
In a common two-for-one split, investors receive one additional share for each share they already own. The stock price is halved—$50 becomes $25, for example—and the number of shares outstanding doubles.
Stock splits can take many forms, although the most common are the 2-for-1 split, the 3-for-1 split, and the 3-for-2 split.
Otherwise, not much else changes—the company’s market capitalization—that’s the total value of all outstanding shares—and other key financial metrics remain the same.
A company’s management and its board must approve a split, then publicly announce their intention to do so. The actual split usually takes place within a few days or weeks.
As far as splits go, Apple’s 4-for-1 split is relatively straightforward.
For every share you hold as of August 24, you’ll receive four shares as of the split date, which is August 31, 2020.
After the split, each share, all else being equal, will be worth one-fourth of what it was pre-split.
So, for example, if Apple shares are trading at $400 per share, and you hold 100 shares, after the split, you’ll hold 400 shares, each worth $100.
It’s not every day that the biggest company in the United States splits its shares. In fact, most of Apple’s tech peers, like Amazon, have avoided stock splits for years.
However, it’s important to remember that splits are just one type of corporate action. Others include cash dividends, stock dividends, spin-offs, mergers, and acquisitions. In other words, corporate actions happen every day and splits are just one example of them.
Why Do Stock Splits Happen?
Many split stocks can be chalked up to basic psychology.
As a stock price climbs, some investors, particularly smaller ones, may view the shares as too expensive and out of reach. A split, in theory, takes the price down to what may be a more attractive or accessible level, while also feeding a notion among existing shareholders that they have “more” than they did before.
Splits also allow people to buy more shares. Basically, investors believe they are getting a “deal” when they can buy more shares at a lower price. However, the value of the stock hasn’t really changed.
Various companies have differing opinions on stock splits. Warren Buffett, for example, has been quite vocal over the years about the foolishness of splits, stating simply that his company, Berkshire Hathaway (BRK/A), will never split.
How Are My Options Affected?
A split, or other corporate action, typically requires no action on the part of the investor. Positions adjust accordingly. However, here are a few things to consider:
- Expiration dates matter. An option expires the same way a carton of milk would. Remember: AAPL set its ex date for the split on August 31, 2020. Options expiring before then are still based on the pre-split price, but anything after the ex date will be based on post-split pricing.
- Non-standard options and liquidity. If you happen to inherit a position in a non-standard option after the adjustment, it’s up to you to decide whether to hang on or liquidate (and perhaps look for another option to trade).
Peter Klink, director of risk management at TD Ameritrade, stated, “Some non-standard options can have less liquidity and wider-than-normal bid/ask spreads. At minimum, it may not make sense to establish new positions once options are adjusted.”
3. What about those greeks? Again, the underlying math remains the same. In the case of options analytics and risks (known collectively as the “greeks”), the aggregate exposure and risk/reward, as measured by the greeks, will remain the same before and after an adjustment.
Delta, a measure of an options contract’s sensitivity to a $1 change in the underlying asset, for example, doesn’t change, because it’s a relationship between the strike price and the stock price, both of which change by the same ratio.
Theta, in contrast, is a relationship between premium and time. When the premium of AAPL options is split, theta per option will be one-fourth what it had been. But if you own four options, the math for the aggregate position will be the same pre- and post-split.
The same goes for vega, which tracks the relationship between implied volatility and options premium. After the AAPL split, a 1% move in volatility will have one-fourth the effect on each option, but if you have four of them, it’ll be the same aggregate exposure.
For investors, seizing on a split as the deciding factor in whether to buy a stock is inadvisable.
For traders, potential benefits of any split-related strategies have become less clear. Years ago, it was common to buy shares after a split because the stock tended to rise toward the pre-split price within a year. More recently, it’s unclear if that phenomenon still holds true.
Ultimately, when a new investor is exposed to the dynamics of a split, it can be a bit jarring. But it’s not the end of the world. Just take the time to step back, dissect, digest, and make your decisions from there.
To a Richer Life,
The Rich Life Roadmap Team