How Stock Splits Affect Your Stocks and Options

Introduction

A stock split occurs when a company on the stock exchange breaks up its shares into multiple pieces. The stock’s value is cut in the same ratio as the number of pieces it was split into.

While stock splits don’t happen every day, you shouldn’t write them off completely. You can still use stock splits to your advantage if you know how to prepare for them.

Stock Split Pricing on Stocks

When stocks split, the underlying company determines a predetermined ratio to divide up the stock. A 2-for-1 split creates 2 new shares for each existing share. A 3-for-2 split creates 3 new shares for every two existing shares.

The stock price is also split in the same ratio. In a 2-for-1 split, the stock price is divided by 2. In a 3-for-2 split, the stock is divided by 3/2.

Suppose you own 100 shares of company XYZ worth $120 (total: $1200). Here’s how different stock split ratios would change your share volume and share price. Note that the total value of your shares would be the same regardless of the split-ratio.

• A 2-for-1 split: 100 shares becomes 200, each worth $60 ($Total: 1200)
• A 3-for-1 split: 100 shares becomes 300, each worth $40 ($Total: 1200)
• A 3-for-2 split: 100 shares becomes 150, each worth $80 ($Total: 1200)
• A 4-for-1 split: 100 shares becomes 400, each worth $30 ($Total: 1200)

Stock splits don’t inherently change the value of a company. However, they do result in higher share volume, liquidity, and may allow you to buy stocks for cheaper.

Limitless Tip:

A reverse stock split combines multiple stock shares and their prices. In a 2-for-1 reverse split, two shares worth $50 would become one share worth $100.

Stock Split Pricing on Options

If you you have open options positions when the stock splits, they’ll get adjusted based on the split ratio.

When the underlying stock splits 2-for-1, your option contract doubles the underlying shares to 200 and divides the strike price by two.

Normally, exercising a $150 put option results in a $1500 trade of 100 shares at $150. When this stock splits 2-for-1, your contract controls twice as many shares (200) but divides the strike price by two. The underlying trade is still at its original trade value ($1500).

Based on the same put option, try calculating the strike price and the underlying share volume in a 3-for-2 stock split yourself. Highlight for the answer: 150 shares at $100 each.

In all cases, exercising the option before and after the stock split should yield the same underlying trade value. The technical name of options adjustment is known as “being made whole.”

How Stock Splits Affect Company Valuation (Market Cap)

Market capitalization is a company’s estimated value based on the worth of all outstanding stock market shares. You can calculate market cap with the following formula:
Market cap = Total Outstanding Shares * Share Price

Suppose Apple (AAPL) has a market capitalization of $2 trillion. That means if you rounded up all the shares of AAPL on the market, they would be worth $2 trillion.

Hypothetically, there could be just one AAPL share valued at $2 trillion, but only one person would be able to hold it at a time. They could also split the stock 1 trillion-to-1, so many more people could own shares at $2 each.

As you can see, stock splits would result in more shares and lower prices. The increased liquidity and affordability make the stock more accessible for anyone interested in buying AAPL stock.

However, share volume and price don’t change the inherent value of the company. Since prices are adjusted based on the number of shares, stock splits don’t directly affect the market cap of the underlying company.

Note: it’s still possible for the stock split to change a company’s market cap indirectly and temporarily (we’ll get into this later).

What Stock Splits Mean for Investors

While stock splits improve affordability, many investors don’t even invest in individual stocks.

Index fund investors generally don’t need to worry about stock splits. Any splits in the fund’s stocks wouldn’t produce in a noticeable change in their index fund position.

Stock splits are also of no concern to traders who have access to fractional shares. Even if they’re unable to afford a particular stock at $1000, they could buy 0.2 (one-fifth) of a share for $200.

Only a few individuals need to pay close attention to stock splits if they want to benefit from the added liquidity and fewer shares.

Stock Splits in the Short-Term

Stock splits result in a lower price tag, which can reduce the financial and psychological barriers to investing. As a result, this may increase the demand for that particular stock and artificially inflate their prices, even if only temporarily.

For example, suppose we have companies ABC and XYZ, both with a market cap of $500 billion. The difference is that ABC shares trade at $50, while XYZ goes for $1000.

Some investors may see “expensive” stock shares as risky, but feel a “cheaper” one is safe. Buying 20 ABC shares at $50 is like buying a single XYZ share at $1000. Between the two stocks, ABC stocks seem more affordable, even though we’re buying the same share of the company.

Beginner stock investors will likely see company ABC as the more attractive option and choose to invest in it. As a result of perceived affordability, ABC’s trade volume and demand increase, which may temporarily inflate the share price.

In the wake of the pandemic and stock market stimulus following it, we’ve experienced a massive influx of new investors and improved market sentiment. Along with the increased bullishness of individual investors, a stock split could be the recipe for stocks to outperform the market in the short term.

Stock Splits in the Long-Term

As we stated earlier, stock splits don’t inherently change the value of the company. While we may see a temporary rally in stock prices, market forces will eventually bring the stock price to fair market value in the long-term.

Therefore, stock splits are of little concern to those who use long-term stock strategies like ‘buy-and-hold.’

Besides, many investors gain market exposure from contributing to their employer-sponsored retirement accounts. In most cases, their retirement funds go into mutual funds, index funds, or electronic-traded funds (ETFs).

By investing in funds, individuals don’t have to worry about share price or affordability. Instead, professional fund managers pool their assets together and allocate them in different stocks. Therefore, they see very little changes from stock splits.

However, investors who pick individual stocks and don’t have access to fractional shares may find a stock is too expensive to ‘dollar-cost average.’ A stock split that reduces the share price is a welcome one to these investors.

Stock Splits for Options Trading

Perhaps the most significant benefit from stock splits is reducing the cost of the underlying stock in specific options strategies.

For example, selling naked options could lead to bankruptcy and debt if the trader doesn’t own the underlying stock. Since options only trade in increments of 100 stock shares, lower prices from stock splits increase affordability of owning those shares.

Suppose you sell a naked call option with a $100 strike, but you can’t afford 100 shares to cover the call. If you receive assignment when the share price hits $120, you’ll lose $20 per share (total loss: $2000).

As there’s no theoretical limit to how high stock prices can go, you could incur infinite risk from selling a naked call. To avoid this problem, you would have to cover the call by owning 100 shares first.

However, you may not have enough capital to buy 100 shares of an expensive stock. Options on a $500 underlying stock require $50,000 to cover the option. Meanwhile, options on a $10 underlying stock requires only $1000 per contract.

Therefore, stock splits may be of interest to option traders if they increase affordability of covering their positions.

Summary

Stock splits are a non-event for the majority of investors. However, select individuals may benefit from increased share volume and lower prices.

Stock splits significantly benefits those who:

• Trade short-term (Day trade, momentum trade, swing trade)
• Don’t have access to fractional shares
• Trade options whose underlying is expensive (subjective)
• Dollar-cost average stocks that are expensive (subjective)

Stock options do not significantly benefit those who:

• Trade long-term (Buy-and-hold, index funds, funds in employer sponsored retirement plan)
• Have access to fractional shares
• Trade options whose underlying is affordable (subjective)
• Dollar-cost average affordable stocks (subjective)