The Capital
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The Capital

101 Guide To Stock Splits

By Charlie Rogers on The Capital

With the recent explosions of Apple and Tesla stock, many are relishing in the fact that the stock is on the rise. However, sometimes that initial feeling of pride is followed by confusion as many new investors may wonder how the stock split is going to affect things such as market order and dividend payouts.

To put an ease on your mind you’ll be happy to know that all of the necessary adjustments are made for you. But it is still good to know how a split works and how it can have an impact.

Stock Split Reasoning

Typically, a stock is split when that company’s share price is starting to look at a little expensive, an example of this being the recent surge in the Tesla stock price.

Let's use Tesla as an example. On the 27th August, 2020 Tesla stock was trading for $2,238.75 a share. Investors that had previously invested at $900 a share are no doubt pretty happy.

But let's look at other motor company’s stock, they are trading well below this figure. Those other companies stock aren’t necessarily a better value than the Tesla stock, but casual investors sometimes make that assumption.

To deal with this reaction, companies will sometimes issue new shares, which diminish the stock price by a proportional amount. Since Tesla announced a 5:1 stock split (also known as a 5 for 1 split), it gives investors 4 additional shares for each share they already own. Now each one is worth a fifth of the original price pre-split. The split will drive additional interest in the company’s stock, but on paper, the investor is no better or worse off than before the split.

Trading strategies

For most trading activity, the effect of a stock split is pretty straightforward. But investors with more complicated positions in the stock — for example, if they’re short-selling it or trading options — may wonder how the split affects these outstanding transactions. If you are one of these people feel free the take a deep breath as your trades will be adjusted in a way that neutralizes the impact on your investment.

Let's dive into short-selling, on the surface, a stock split might seem like a wave good luck for the short-seller. As if you sold 5 Tesla at $2,238.75 each, you can now acquire them at just $498, right?. Well no, that's not the case. The brokerage will adjust your order so that you’ll owe five as many shares. When all is said and done, the stock split doesn’t affect your position one way or the other.

The same is true with options, which gave holders the right to buy or sell a stock at a pre-determined price within a certain period of time. If you own a Tesla call option with a strike price — meaning you have the right to purchase the stock at a certain price. The split doesn’t mean you’re suddenly “out of money” since it split. The Options Clearing Corporation automatically adjusts the contract to include x5 as many shares if we are following Tesla. In this case, the investor comes out even as before the split.

Dividends

One big thing that investors question when a stock splits is whether their new shares are eligible for dividends, unfortunately, this usually isn’t the case. Only shares that are held as of the dividends date of record qualify for dividends payout.

For situations when the stock split occurs before a dividend record date, the dividend will for the most part be paid out for the newly created shares as well, except that the dividend likely will be split compared to the previous time. This is normally due to the fact that companies want to maintain the amount of dividends issued.

In reality, most companies avoid announcing a stock split close to the date of record in order to avoid any confusion.

Bottom Line

As a bottom line in most cases, either the company itself or your investment brokerage of choice will automatically adjust your trades to reflect the new price of a stock that has split, but still, as an investor you should take extra care when figuring out their tax basis and by re-submitting any stop orders placed prior to the split.

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