Effect Of A Reverse Stock Splits To Short Sellers(Good or Bad)

When a publicly traded company wants to increase the stock price of common stock, they use a technique called reverse stock split, which is allowed in a stock exchange. However, is it a good idea to do it? So, I searched for an answer, and here is what I found.

Reverse stock splits 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.

As a general rule in the stock market, 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 done it because they feel the price is too low.

Often they want to be on the radar of institutional investors.

Institutional investors usually buy common stocks for more than $5 per share because the risk of being delisted is unlikely.

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 reverse split, the market value of the stock remains the same. The company’s stock will not change in total value.

As a caveat, a reverse stock split is not the same with a stock buyback.

Look at this example:

Company’s market capitalization$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) / Market Capitalization$2,000,000,000

After the reverse split, the market value or market cap stayed the same, although there are fewer shares. However, the action of the management can lead to bearish sentiment in the stock.

The outstanding shares or existing shares are now half in number 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 company’s shares or outstanding shares.

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

However, since investors or shareholders 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 have seen it happen repeatedly. 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 terrible 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 or smaller investors to get out fast. It creates an opportunity for short-sellers for a short period.

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 you knew 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 still continue moving down.

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

Getting out of a trade may help reduce the losses if a big potential investor or mutual fund may come in.

They may come in because of the company is now less volatile.

Reverse Stock Split Good or Bad?

How do reverse stock splits affect short sellers? A reverse stock split is usually good for short-sellers, considering the increase in its stock price without increasing market capitalization. So, there is no value increase, and the only reason for the split is to make the price seem higher to avoid looking too small.

It differs from a regular stock split, which is a method used by top managements to lower the price of the stock if it seems expensive.

More Reading: Does Market Cap Equal Valuation?