Publicly traded companies may decide to split their stock for various reasons. If a company's stock price has gone up, the price may be too high for investors to purchase shares. A stock split lowers the price of shares making them more attractive
A stock split means that existing shareholders receive additional shares, but the value of the shares will not increase due to the stock split. When a stock split is announced, an options contract undergoes an adjustment called "being made whole," which adjusts the terms of the contract so that the value does not change.
Key Takeaways
- A stock split means that existing shareholders will receive additional shares, but the value of the shares will not increase at the time of the split.
- Similarly, a stock splitwill increase the total number of shares outstanding but willnotincrease the market capitalization of a company.
- A stock split announcement means that an options contract undergoes an adjustment called "being made whole."
What Is a Stock Split?
"Being made whole"means the options contract is modifiedso that the holder is neither negatively nor positively affected by the corporate action. While a stock split adjuststhe price of an option'sunderlying security, the contractis adjusted so that any changes in price due to the split do not affect the value of the option.
Ifyour option is purchased post-split (that is, after the split is announced),itwill not be adjusted because it already reflects the post-split price of the underlying security. TheOptions Clearing Corporation will automatically make these adjustments for the sake of orderly and smoothfunctioningmarkets.
Stock Split Calculations
If a company with 20 million shares announces a 2-for-1 stock split, shareholders receive one additional share of stock for each share they already own. The company's total number of shares outstanding is now 40 million. Because of the split, the value of each share is halved. A share that was worth $16 before the split will now be worth $8.
A stock split will not increase the value of each share, but each stockholder will receive additional shares.
The "being made whole" calculation is relatively straightforward for options. Each option contract typicallycontrols100 shares of an underlying security at a predetermined strike price. The new share ownership isgenerated by taking the split ratioand multiplying it by 100 while the new strike price is generated by takingthe old strike price and dividingit by the split ratio.
For example, if you buya calloption that controls100 shares of XYZ with a strike price of $75. If XYZ announces a 2:1 stock split, the contractwould now control200 shares with a strike price of $37.50. On the other hand, if the stock split is 3 for 2, the option would control150 shares with a strike price of $50.
Stock Split vs. Reverse Split
A reverse split also reverses the adjustment process but in a different way. A reverse split or reverse stock split announcement means that the number of existing shares of stock are consolidated into fewer, higher-priced shares.
The existing total quantity of shares is divided by a number such as five or 10, which would then be called a 1-for-5 or 1-for-10 reverse split, respectively. A reverse split is also known as a stock merge and is the opposite of a stock split, where a share is divided into multiple parts.
Stock Splits and Market Capitalization
While a stock splitincreases the total number of shares outstanding, it willnotincrease the market capitalization of a company—the total market value of its shares. Thus, a company with 20 million shares outstanding at $20 per share has a market capitalization of $400 million.
A 2-for-1 stock split means that both the stock and its price are halved, and the total market value of the company's stock remains the same (40 million shares at $10 per share is $400 million).
Is a Split Good for a Stock?
Yes, generally a split is good for a stock. While the value of the company's stock does not change, a stock split typically makes a stock more affordable for some investors who may not have been able to afford the shares before. This increases interest in the stock and oftentimes leads to increased investor demand. A stock split is considered a bullish move.
What Is a Stock Split?
A stock split is when a company decides to split one share into multiple shares. This increases the total shares outstanding for existing investors but does not affect the value of the stock. For example, if a company had a share price of $100 and decided to split one share into two shares, an investor that had one share of the stock at $100 would now have two shares of the stock at $50 each.
Is a Stock Split a Good Time to Buy?
A stock split does not mean that a company's financial profile has changed and that it is now a better investment. A stock split simply means that the share price is now lower and there are more shares outstanding. If a company was a bad investment before a stock split, it would still be a bad investment. If it were a good investment before the split, it would still be a good investment, and now may be more affordable to some investors due to the reduced share price.
The Bottom Line
Stock splits are a common occurrence in company shares. They help reduce the price of a share to make it more affordable for investors. The total value of your shares does not change. Similarly, with an option on a stock, the option is adjusted so that the value does not change.
