Effect Of A Reverse Stock Splits To Short Sellers

When a company wants to increase the stock price, they use reverse stock splits. However, is it a good idea to do it? So, I searched for an answer, and here is what I found.

Reverse stock splits do affect short sellers in a good way. Company management does it to increase the share price because the price of the stock is too low. Also, some of them have a greater risk of being delisted.

Generally, you short the stock after the split. However, do it for a short period. The company may be on the verge of being removed from the stock exchange.

In the first place, why would the company management do it? The action has created adverse effects on the share price.

Most of the time, the investor’s sentiments have become bearish after every reverse stock split.

I’m not saying you should short every time a reverse stock split occurs. The management may have decided to do it because they feel the price is too low.

Also, sometimes they want to make the share price expensive so that they can reduce the volatility of the stock. It can discourage speculator trading.

Example

At the time of the split, the market value of the stock remains the same.

Take a look at this example:

Market value$2,000,000,000
Stock price before the stock split$2 per share
Outstanding shares(before)1,000,000,000
Price After 2:1 reverse stock split$4 per share
Outstanding shares(after)500,000,000
Market value(after)$2,000,000,000

After the reverse split, the market value stayed the same. However, the action of the management can lead to bearish sentiment to the stock.

The outstanding shares had reduced in half after the 2:1 reverse stock split.

You can compute the market value by multiplying the price per share by the outstanding shares.

To get the price per share, divide $2,000,000,000 by the outstanding shares.

Although the price of the stock has increased to $4 per share, the short-sellers have not incurred losses.

However, since investors may consider the stock as expensive, they may sell their shares which is favorable for short-sellers.

I have accumulated profits in the past by just shorting reversed stock splits.

I personally have seen it happen over and over again. Let’s discuss why it happens often.

It does not happen 100% of the time, but if you have set your risk-reward ratio you can earn a lot.

Negative Effect

Based on our discussion above, you may have experienced a light bulb. You probably learned something new that no one has discussed anywhere.

A reverse stock split has earned a bad reputation in the stock market. Some traders say that it is a way for the weak stock to increase the price to prevent delisting.

It is a warning signal for investors to get out fast. It creates an opportunity for short-sellers for a short period of time.

Always look out for reverse stock splits and look for good entry points in the market.

The negative effect of it has given traders an additional edge in the markets. However, this method is not absolute.

I know that you knew that nothing works every time in the stock market. How many times have you experienced losing trade while using a robust trading system?

Always set your stop loss in case the trade is unfavorable to you. Nothing can save you but this, in case a catastrophe happens.

Trading strategies need to be updated and fine-tuned. A trading strategy may work this year, but it might do what you expect the system to do next year.

 

Positive Effect

Once the price has declined so much because of short-sellers, buyers may come in and move the price up. It does not mean that bearish sentiment has become bullish though.

Well, the price may continue moving down.

It is time for short sellers to buy back their share. If you are short at this time, you better get out of the trade.

Wrap Up

In the final analysis, reverse stock splits offer opportunities to short sellers. Do not be afraid to short the security if you have a chance.

More Reading: Complete Guide to Average Share Price Formula