Revealed: How Stock Splits Help Options Traders

| August 20, 2020 | 0 Comments

stock splitsStock splits re-entered the trading lexicon and grabbed the headlines when “Apple (AAPL),” and then “Tesla (TSLA),” announced they would be conducting a 4-for-1 and 5-for-1 stock split, respectively.

Following the announcements, shares of each are up 18% for AAPL, and TSLA has zoomed up 40% in just six days.

You couldn’t ask for two better poster children as representatives of the current stock market; AAPL as the now dominant legacy tech company and TSLA as the disruptive up-and-comer that is poised to change the world.

Of course stock splits, as all media reporting agencies are quick to point out, do not change the fundamental value of the company or your holding.  You now have four quarters rather than one dollar.

But, the psychology factor is huge. And it will be a boon for those that want to add option strategies to their trading portfolios. 

Back in the late 1990s, at the peak of the dot.com craze, not only did stock splits become a daily occurrence, but there were trading frenzies gunning stocks ahead of anticipated splits; the old Yahoo split 5 times within 18 months, and Lycos twice in a year. Basically, as a stock crossed above $100, it became a split candidate and people wanted in on it.

It made no sense then and not much more now. Except for options traders. Before I get to why two nickels are better than a dime for options traders, let’s look at why stock splits were mostly abandoned over the past 20 years.

The dot.com bust followed by the financial crisis basically knocked individual investors out of the game and handed the reins to large funds, particularly Exchange Traded Funds (ETF— based on the major indices such as “SPDR 500 Index (SPY)”.  Institutional investors actually liked trading stocks with higher dollar prices as it meant they needed to buy fewer shares to achieve their allocation. That meant lower trade commissions.

But now as commissions have moved to zero, that benefit no longer holds much sway. Instead, we are seeing a resurgence in retail and individual accounts have a high stock price, such as “Amazon’s (AMZN)” near $4,000 per share, or TSLA or even a mundane name such as “Home Depot (HD),” near $300.

Currently, more than two-thirds (70% of the S&P 500 SPY stocks) are trading above $140 per share. This compares to less than 20% average for the 30 years prior to 2008.

It seems like AAPL and TSLA may have opened the floodgates for a new era of splits.  Even Jim Cramer of CNBC has called for some of the largest and best-known companies to do stock splits.

The thinking is this will help the trend of new investors, which might have relatively small accounts, gain access to buying shares in AMZN, TSLA, AAPL etc.

Again, there is a psychological component in that it just feels better to own 5 shares than just one.  But there is also a very real issue of capital constraints to participating in a stock with share price in the hundreds if not thousands.

Some people might point to the recent development of fractional ownership, such as Fidelity’s slices. But, many firms don’t offer these options.

More importantly, fractional ownership does nothing to help option traders. Stock splits do.

The progression of implementing option strategies into your investments usually starts with owning shares and then engaging in a covered call strategy; selling a call option against the shares you own.

Given that each option represents 100 shares of the underlying stock, one must own at least 100 shares to employ this basic income-generating strategy. 

So, for example, if you wanted to have a covered call in AAPL at its current price of $460, it would require $46,000 to purchase the initial 100 shares.  That will be cut by 75% to around $11,500 once the stock split takes effect.

Likewise, most cash-secured put selling strategies would become much more accessible if the nominal dollar price of the stock was brought back down from the stratosphere.

Even active options trading, such I do for myself and in the Options360 service, where I use basic spreads, has been shut out trading high-flying names from AMZN to “Trade Desk (TTD)” due to the high dollar amount in which a one spread contract can cost more than $2,000.

I understand stock splits have no real impact on the intrinsic or fundamental value of a company. But, as an options trader, I welcome splits which will allow greater access to employing option strategies to enhance my returns.

Note: This article originally appeared at Option Sensei.

 

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Category: Options Trading

About the Author ()

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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