Reverse stock splits are often viewed negatively by investors, and for good reason. Unlike forward splits which typically signal strength, reverse splits are usually a sign of trouble. However, understanding how to trade these events can help you avoid losses and even find profitable opportunities.
What is a Reverse Stock Split?
A reverse stock split is the opposite of a regular stock split. Instead of dividing shares into smaller pieces, the company combines multiple shares into one. This increases the share price while reducing the number of outstanding shares.
Key concept: In a 1-for-10 reverse split, if you owned 100 shares at $1 each ($100 total), you would now own 10 shares at $10 each (still $100 total). Your total investment value stays the same, but you own fewer shares.
Why Companies Do Reverse Splits
Reverse splits are typically done for defensive reasons:
- Avoid delisting: Exchanges like NYSE and NASDAQ require minimum share prices (usually $1). A reverse split can boost the price above this threshold.
- Attract institutional investors: Many funds cannot buy stocks under $5 or $10.
- Reduce volatility: Higher-priced stocks tend to have smaller percentage swings.
- Improve perception: A $20 stock looks more legitimate than a $0.50 stock.
- Meet options requirements: Some brokers have minimum price requirements for options trading.
The Warning Signs
A reverse split announcement is often a red flag. Here is what it typically indicates:
- The stock has declined significantly (often 70-90% or more)
- The company may be struggling financially
- Management is trying to artificially prop up the share price
- There may be ongoing dilution from stock offerings or convertible debt
Example: The Reverse Split Death Spiral
Company XYZ trades at $0.50 and announces a 1-for-20 reverse split, pushing the price to $10. However, the underlying problems remain. Over the next year, the stock falls back to $1, losing 90% of its value again. Some companies go through multiple reverse splits before eventually going bankrupt or being delisted anyway.
Trading Strategies for Reverse Splits
Strategy 1: Short Before the Split
Many traders short stocks that announce reverse splits, expecting continued decline. The logic is simple: if the company needs a reverse split to stay listed, the underlying business is probably weak.
Warning: Shorting around reverse splits is risky. Short squeezes can happen, and borrowing shares can become expensive or impossible. Always use proper risk management.
Strategy 2: Avoid and Move On
The safest strategy is often to simply avoid stocks undergoing reverse splits. Statistical studies show that stocks completing reverse splits tend to underperform the market over the following 1-3 years.
Strategy 3: Wait for Post-Split Decline
If you believe in the company long-term, wait until after the reverse split when the stock often drifts lower. You may get a better entry point than buying before the split.
Strategy 4: Play the Bounce
Some traders look for oversold conditions after a reverse split. When a stock gets too beaten down, it can bounce 20-50% before resuming its decline. This is a high-risk, short-term strategy.
Example: Bounce Trade
After a 1-for-10 reverse split, stock ABC opens at $8 but immediately sells off to $5 as shareholders dump their positions. Over the next few days, bargain hunters push it back to $7. A trader who bought at $5 and sold at $7 captured a 40% gain, even though the long-term outlook remains poor.
Historical Performance Data
Research consistently shows poor outcomes for reverse split stocks:
- One study found that stocks completing reverse splits underperformed the market by 30-50% over three years
- About 60% of reverse split stocks continue to decline in the first year after the split
- Many companies that do reverse splits eventually get delisted anyway
- The larger the reverse split ratio, the worse the subsequent performance tends to be
Fractional Shares and Cash-in-Lieu
An important detail many traders miss is what happens to fractional shares. If you own 15 shares and there is a 1-for-10 split, you would get 1 full share plus cash for the 0.5 fractional share. This cash-in-lieu payment is a taxable event.
Options Considerations
Reverse splits create complex situations for options traders:
- Strike prices are adjusted proportionally
- Contract deliverables change (may deliver different number of shares)
- Liquidity often dries up in adjusted options
- Bid-ask spreads typically widen significantly
Pro tip: Close out options positions before a reverse split takes effect. Adjusted options are often illiquid and difficult to trade at fair prices.
Exceptions: When Reverse Splits Can Be Positive
While rare, some reverse splits do work out:
- Strong company, temporary problems: A quality company that hit a rough patch may recover after cleaning up its share structure.
- Acquisition target: Sometimes a reverse split precedes a buyout at a premium.
- Industry turnaround: If the entire sector is depressed, a reverse split during the bottom can look smart in hindsight.
- Strategic restructuring: Coupled with genuine business improvements, a reverse split can mark a turning point.
Red Flags to Watch For
- Multiple reverse splits: A company doing its second or third reverse split is almost certainly in trouble.
- High ratio splits: A 1-for-50 or 1-for-100 split indicates severe price deterioration.
- Simultaneous dilution: If the company is also issuing new shares, the reverse split is just delaying the inevitable.
- Auditor warnings: "Going concern" language in financial statements is a major red flag.
- Executive departures: Management leaving around a reverse split often signals they know something.
Track Your Corporate Event Trades
Pro Trader Dashboard helps you monitor and analyze your trades around corporate events like reverse splits. Track your performance and learn from each trade.
Summary
Reverse stock splits are usually warning signs rather than opportunities. While some traders can profit from shorting or playing bounces, the safest approach for most investors is to avoid these stocks entirely. If you do decide to trade around reverse splits, keep your position sizes small and have a clear exit plan.
Looking for more positive corporate events? Read our guide on trading forward stock splits or learn about special dividend opportunities.