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On Wednesday, we discussed the biggest mistake traders and investors are making this month.
But today, I want to talk about another major mistake traders are making.
Now to be fair… they're making it because they're simply misinformed.
But what they're misinformed about provides 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
I am fascinated by how blasé some of the financial pundits out there are when it comes to a stock split. They say that the value of your holdings doesn't increase after a stock split and that the value of the position is still the same as it was before.
Well… no kidding!
But unlike our pundit friends, I find stock splits to be much more exciting.
See, after a stock split, the stock has a tendency to go back to its pre-split price. Now it can take a year or more to happen…
But as far as I'm concerned, the opportunity to double the value of your portfolio within one year – by doing nothing more than owning the stock in first place – is a pretty good thing.
The real excitement lies in the opportunity of the stock price ticking back up to its original price… and when this happens, this means that the value of your position in that stock has DOUBLED!
But before we go any further, let's talk about what a stock split is…
As you may already know, all publicly traded companies have a set number of outstanding shares (the company's stock that's held by all of its shareholders). A stock split is when the company's board of directors decides to increase the number of outstanding shares by giving more shares to its current shareholders. There's no value added to the stock when this happens; it just means that one share of stock is split into two shares, making the price per share lower than it was before the split.
Have you ever asked for two $5 bills in exchange for a $10 bill before?
You can think of a stock split in exactly the same way. Instead of having one bill in your hand that's worth $10, you'll end up with two bills in your hand… but you're still left with $10.
When a company announces a stock split, it's often a good sign of the company's "health." A stock split can mean that a company is doing so well that it can afford to drop the share price to attract new investors.
You may have also heard of a reverse stock split, which works in the exact opposite way. Instead of increasing the number of outstanding shares, the company's board of directors decides to decrease the number of outstanding shares. So here, two shares of stock become one share, making the price per share higher than it was before the split.
Have you ever asked for one $10 bill in exchange for two $5 bills before?
Think of a reverse stock split in this way. Instead of having two bills in your hand worth $5, you'll end up with one $10 bill instead.
However, unlike its counterpart, a reverse stock split is often a bad sign of a company's "health." A reverse stock split can mean that the company is in trouble and needs to boost the price of its stock to avoid being delisted. A company that announces a reverse stock split might be one to stay away from.
Stock splits (and reverse stock splits) are typically reflected in ratios. Here are some common stock split ratios you may have seen:
I. 2:1 (2-for-1): you'll end up with two shares of stock for the price of one share
II. 3:1 (3-for-1): you'll end up with three shares of stock for the price of one share
III. 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:
I. 1:2 (1-for-2): you'll end up with one share of stock for the price of two shares
II. 1:5 (1-for-5): you'll end up with one share of stock for the price of five shares
III. 1:10 (1-for-10): you'll end up with one share of stock for the price of ten shares
When the Stock Splits, the Options Split
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 long-term equity anticipation securities (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 remain 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 Walt Disney Co. (NYSE: DIS) as our example on Wednesday, 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.
Investors would pay $10,000 to own 100 shares of the $100 stock. 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 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 (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, 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 its stock could prove lucrative for you… with minimal risk.
Avoid the Biggest Mistake Traders Make: Traders start making mistakes when markets get choppy, and right now they're committing one of trading's cardinal sins. We've got the information you need to avoid this trap – these numbers are critical to succeeding in today's markets…
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.