A stock split can drastically change the price of a stock and the size of your position. When you are short a stock, the occurrence of a stock split can add even more confusion. By understanding how shorting works and what occurs during different types of stock splits, you can be prepared for the sometimes startling changes that can occur to your short position on the day of the split.
Shorting occurs when a stock is sold before it is purchased. When you do this, you're making a bet that the stock price will drop, and you will profit if it does so. For example, if you short 100 shares of a stock at $10, your account will be credited with $1,000, but you will be negative 100 shares. At some point you must buy 100 shares to offset your negative share situation because your broker has essentially borrowed you someone else's shares. If you can buy the 100 shares back at $9, costing you $900, you reap a $100 profit. If the stock moves higher, however, you face potentially infinite losses since there is no cap on how high the price can go. If you are short, you also must pay any dividends the company issues.
There are two common types of splits: a reverse and a forward. A reverse stock split occurs when the amount of shares outstanding is decreased. The company publishes a statement defining how many shares you will receive for each share they own. If a 1:2 reverse split occurs, and you own 200 shares, you will own only 100 after the split. A forward stock split occurs when the number of shares outstanding is increased. If you own 200 shares, after a 2:1 forward split, you will own 400 shares.
Stock Price and Splits
When the split occurs, the price of the stock is adjusted to reflect the new number of shares outstanding. In the case of a reverse split, the price will increase, as now fewer shares are outstanding. When a forward split occurs, the share price will decrease because more shares are outstanding. While the stock price and number of shares you own change, the price is always altered by the split ratio, which means that the value of your holdings is not materially affected. You either own more shares at lower price or fewer shares at a higher price; the market capitalization -- the number of shares outstanding multiplied by the share price -- does not change.
Short During a Split
If you have a short position during a stock split, the scenario is similar. For example, you are short 100 shares, and the current share price is $10. If the company does a 2:1 forward stock split, you will now be short 200 shares, but the current share price will be adjusted to $5 on the day of the split. All past price action is adjusted so you do not gain or lose on the split. Prior to the split, your position was valued at $1,000, or 100 times $10. After the split your position value is still the same: $1,000, or 200 times $5.
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