Reverse stock splits have become a popular way for companies to avoid being delisted from major stock exchanges. Reverse stock splits also deter removal from major stock indices.

Moreover, it helps to remove some of the negative connotations associated with being a “penny stock.” Our community some times looks for stocks with upcoming reverse stock splits because this could be a catalyst for a breakout trade. Let’s take a look at how reverse stock splits work, they affect a stock and why companies may conduct a reverse stock split.

Reverse stock split explained

Unlike a traditional stock split, a reverse stock split reduces the total number of a company’s shares outstanding. Consequently, there is an increase in the stock price. That said, it does not have a fundamental effect on the company’s market value immediately after the corporate action.

For example, assume a company conducts a 1-for-5 split, and you owned 1,000 shares of the company. After the split, you would only own 200 shares of the stock, or 1,000 divided by 5. The price where you owned the stock would be 5 times the price the day before the reverse stock split. Therefore, the market value of the stock position would not change.

Since there is a decrease in the number of outstanding shares, there is a decrease in floating shares. That means if there is a high short interest, the stock could potentially squeeze and cause a run up. That said, let’s look at some examples of reverse stock splits that have run up after the companies announced a reverse stock split.

Reverse stock split examples

For example Infosonics Corp (IFON) conducted a 1-for-5 reverse stock split. Remember, this divides its outstanding shares by 5, and reduces the floating shares.

That said, with a short interest of 12%, this could squeeze once shorts start covering due to the low number of floating shares, which was just over 500K.

Here’s what happened with IFON:

Reverse stock split examples

Take note, these are the split adjusted prices for IFON. Before IFON’s reverse stock split, the stock dropped a point before rebounding. The day after, IFON popped over 3 points.

That in mind, it’s worth it to follow reverse stock splits to see whether a there’s a trade in the stock. If there’s a high short interest and an upcoming reverse stock split, you might want to keep the stock on your radar for a breakout trade.

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Jason Bond runs JasonBondTraining.com and is a swing trader of small-cap stocks.

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