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Editor's Note: When a stock splits, its options split too. You can play that relationship for an easy double with this strategy Tom shared last year. Here's how…
Today, I want to talk about a major mistake traders tend to make.
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.
Let's go.
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:
- 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
When the Stock Splits, the Options Split
About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.