In The Social Network — the movie based on the story of the start of Facebook — there’s a key scene in which co-founder and former CFO Eduardo Saverin had his shares diluted. You don’t have to be an insider or own a hot stock for this to happen, just an ordinary shareholder, because companies sometimes dilute their own shares.

With that in mind, it’s important to understand the concept of dilution, and how it might affect you.

Dilution explained

In laymen’s terms, dilution is a reduction in the ownership percentage of a company, often due to an issuance of new shares through a public or secondary offering. However, that’s not the only way your ownership percentage can be diluted, as dilution also occurs when holders of stock options (such as corporate officers and employees) exercise their options, increasing the total number of shares outstanding, and diluting existing shareholders in the process.

When you’re trading, any corporate action that could dilute shares creates high potential for a stock’s share price to fall. This is primarily due to the effect on shareholders’ ownership, and the earnings-per-share reduction that is a byproduct of dilutive moves.

Here’s an example in which a company looking to raise capital announced a secondary public offering. On April 6, 2017, BioTime Inc (BTX) announced a secondary public offering, looking to raise gross proceeds of $75M. The microcap company had a market cap of roughly $350 million at the time, so it was a large dilution, leading the stock to fall.

 Check out BTX on the daily chart:

Source: TradingView

The Bottom Line

Understand how dilution works, and how it could affect your ownership, as well as stock price. While dilutive events don’t happen every day, you don’t want to be caught unaware when a company announces a secondary public offering and increases the potential for its share price to take a dive.

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  Jeff Williams is the lead trader of PennyPro.com. He is a short-term trader of stocks under $10 a share.

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