The subject of stock splits can cause a lot of confusion for traders and investors in stocks. In this article I am going to explain what stock splits are, why companies choose to split their stock, and finally explore whether stock splits provide any opportunity to traders to generate profit from the market.
What are Stock Splits?
The dictionary definition of a “stock split” is a corporate action where a company divides its shares into multiples. For example, company ABC Incorporated legally decides and announces that each of its ordinary common stock are going to split into ten shares (this would be known as a “ten-for-one” stock split). This has the effect of every stock owner seeing their number of new shares owned as multiplied by the split factor. All other things remaining equal, if each of the old shares are worth $100, then the new split shares will be worth $10 each. This is something I will explore more deeply later in this article.
Why Companies Split their Stock
It can be seen from the simple explanation in the preceding paragraph that this is a very simple and seemingly trivial and pointless procedure. Why do companies bother splitting their stock? Well, there are a number of reasons why it is useful for companies to undertake this procedure:
A stock split, as we have already seen, should have the effect of bringing down the price by the factor of the split. This can be very useful if the share price has risen by a great deal and become relatively expensive per share, which can have the effect of deterring small investors. For example, Apple Inc. undertook a 7 for 1 stock split in the summer of 2014 largely because its share price had risen steadily to reach a spectacular $645 per share. The split by a factor of 7 reduced the price to a much more affordable $92 per share.
A less widely understood reason why a company might choose to undertake a stock split is to generate greater liquidity in its stock. The price does not just fall, the number of shares in circulation increases too, by the factor of the split. This can cause not only greater accessibility to buyers as we have seen, but also it gives stock owners greater options to sell smaller holdings and these two factors can combine to generate greater market liquidity in the stock. Greater liquidity may have the effect of lowering the bid-ask spread that is quoted by market makers dealing in the stock on approved exchanges, which again makes trading in the stock easier and creates a better market for the company’s shares.
Can Traders Take Advantage of Stock Splits?
Academic studies undertaken since the 1990s have tended to indicate that stocks which have just been split tend to outperform the market as a whole for a while. Whilst this might seem too good to be true, a quick consideration of some of the likely reasons why this might be true show it is quite plausible:
Companies tend to split their shares when the price has become too “expensive”. Consider that for the price to have become too “expensive” it is very likely that the price has been rising for some time, and is also either at or very close to its all-time high price. This means that stocks that are split have probably been exhibiting excellent bullish momentum, which several academic studies have shown is a winning trading strategy if applied consistently.
Companies are also more favorably inclined to split their shares when the Board of Directors believe that the share price is likely to keep rising and the company is likely to continue performing strongly in its market. This is not infallible, but such “insider” confidence can be a good indication of a company whose share price has a good prospect of rising in the near term.
As described earlier, the action of a stock split usually has the effect of increasing liquidity and opening up more of the retail market. This can generate some bullish action as the split will attract retail buyers, driving the price up beyond the split factor’s division of the pre-split share price.
There is plenty of academic evidence that buying splitting stocks can be an effective, outperforming stock trading strategy, and that the optimum period to hold such stocks is for three years following the split. Of course, an exact period of three years is probably too precise a time-based definition to usefully provide sound guidance as to trade exits, but it is possibly a good maximum period for which the bullish effect of the split can be expected to last for.
Of course, you could also draw another logical conclusion, which would be to short stocks which have just undergone reverse splits of their stock. Bear in mind that the optimal time period to hold stocks short tends to be less than when holding them long.
Unfortunately there are no ETFs offering recently split stocks, so you won’t be able to buy these stocks through most Forex brokers. Traders implementing this type of strategy would have to identify the stocks and buy them directly.