What is a stock split?
Surely you have heard of a stock split, but do you know what it actually is and what it is good for?
What is a stock split?
As a shareholder, you own part of a company. It’s exactly the same as owning a piece of a cake. Let’s say a confectioner divides a cake into 4 pieces and charges 8 Euros for each piece. So the cake has a value of 32 Euros. Since hardly anybody wants to spend 8 Euro for a piece of cake and the pieces are too big for one person anyway, the interest in this cake is very low. So the confectioner decides to divide the single pieces again into 4 more pieces and charges only 2 Euro for each piece. So there are now 16 pieces. The total value of the cake is still 32 Euro. Now the people come and the cake is sold out quicker than he can watch. If you still want a quarter of the cake, you buy 4 pieces for 8 Euro.
And just like with the cake it works with shares. If the value of a share increases too much, the buying interest decreases. For example, an Amazon share costs over $2300 at the moment, and those who are just starting to build up a stock portfolio may not even be able to afford a single Amazon share. Since one should diversify a portfolio, very expensive shares are no longer bought so often. If Amazon would split the shares 1:10, each share would only cost $230 and probably attract more investors.
Investors who already own Amazon shares would have 10 times as many shares in their portfolio after the split, but they would have the same total value.
What is a reverse stock split?
In the case of a reverse stock split, the shares are not increased as in the case of a stock split, but reduced. Companies do this when the price of a share is too low and for this reason no longer attracts investors. Suppose a share is trading at 2 euros and I want to buy put options with an exercise price of 2 euros. The options cost 0.10 Euro (€10 per contract). Now my broker charges 1 Euro trading fees per option contract. If I buy 10 contracts now for €0.10 and sell them later for €0.12, then I have earned €20 on the trade, but I still have to pay €20 trading fees to my broker, so at the end of the day I have earned nothing.
If the stock would cost €20, then the put contract would cost €1.00 and I could sell it for €1.20. Now that I only have to trade one contract and not 10, my trading fees would drop from €20.00 to €2.00 and I would have earned €18.00 on the trade.
Shares, ETFs and ETPs should be neither too expensive nor too cheap. Stock splits can be used to adjust the price and thus make them more attractive to a wider audience.