How to profit from a reverse stock split?

Key Takeaways

• A reverse stock split could be a sign that the market has lost confidence in the company
• During reverse stock splits, it could be a good time to short the stock
• Understanding the reasons behind the split can provide more insight into the trajectory of the stock

Introduction

Looking to understand what it is and how to profit from a reverse stock split? As an investor, I too search for opportunities presented by the markets, and a reverse stock split can act as one of these profit-taking opportunities.

What is a reverse stock split?

Unlike a forward stock split, a reverse stock split is simply a company increasing the cost of its shares without changing its market cap. For example, if you owned 2x shares at $5, after a 2:1 reverse stock split you would own 1x share for $10.

Companies conduct a reverse stock split for several reasons however, the key ones are to ensure the company's stock meets its listing criteria and to gain the attraction of new investors. In most cases, the opposite occurs and a reverse stock split could be a sign of company failure.

How can I make a profit during a reverse stock split?

If a reverse stock split is a sign of a company's decline, then how to profit from a reverse stock split? Considering you are now aware that a stock may begin to decline, you can take advantage of this by shorting the stock.

What is shorting a stock?

Shorting a stock is an investment strategy investors use to 'bet' against the market. Investors will borrow stock at a certain price and if the stock goes down in value, they purchase the stock at a lower price and return it to the original owner pocketing the difference.

For example, if you borrow stock at $10 and the stock's price decreases to $1, you would buy the stock for $1 and return it to the original owner, profiting $9 in the process.

How does shorting during a reverse stock split help?

In many cases, a reverse stock split indicates a loss in confidence in the company. Due to this conception, the stock's price usually begins to decrease, presenting a good opportunity for you to short its stock.

This could be considered a good strategy that has proven to be effective during times of reverse stock splits. However, although reverse stock splits usually mean a company is heading toward disaster, it can sometimes be the opposite.

Examples of successful reverse stock splits

In 2011 Citi Group (C) issued a 10:1 reverse stock split, reducing its outstanding shares from 29 billion to 2.9 billion. The stock was at $4 and after the split became $40. Citi Group's shares are currently trading at $79.46, an almost 100% increase over 14 years on.

If you are considering shorting a stock during a reverse stock split, you will certainly want to gauge your risk level and set any stop losses. Shorting a stock is extremely risky and losses can be unlimited.

Should I sell before a reverse stock split?

This is the question. Upon hearing about a company's potential reverse stock split, I usually sell the stock. The reason for this, as discussed above, is that the market's confidence in that stock may have become increasingly weak.

However, the decision to sell or hold often rests on the reasons behind the split. If the company is conducting a reverse stock split to elevate share prices and attract new investors, it's crucial to understand the objectives driving this strategy.

Analyzing the company’s financial statements and assessing metrics such as the price-to-earnings (P/E) ratio, earnings per share (EPS), and other vital ratios highlighted in the company’s earnings report can provide clearer insights into the potential future trajectory of the stock and reasons behind the split.

Frequently Asked Questions

Is a reverse stock split good?

In most cases no, it is not good for a stock when it reverse splits. This is an indication of a failing company and a loss in investor confidence, meaning you could lose money if investing in a stock that's about to reverse.

Can a stock go up after a reverse split?

Yes, but there are not many examples of this happening. In most examples, a stock's recovery process takes a substantial amount of time. It could take years before seeing a recovery or even profits after a stock reverses.

Is it better to buy a stock before or after it splits?

There is no correct answer to this as a stock would likely act very volatile before, during and after a reverse stock split. But, in most cases, a stock would usually decrease in value during these events and in some cases lead to a company's bankruptcy.

Conclusion

Answering the question of how to profit from a reverse stock split points more toward understanding how to short a stock. In most cases, we see a decline in stock price rather than an increase. As an investor, you should be cautious before investing in a stock when it reverses its stock.

Ensure you conduct all the necessary analysis before considering investing in a stock. A great tool that uses powerful AI to analyse stocks is Intellectia AI, I highly recommend you give it a try.