Many new traders, especially those with limited amount of money, face a big challenge when buying stocks. They find that all stocks that they love are unaffordable.
For example, those who love Warren Buffett are surprised to find the stock price of his company trading at $263,400. Similarly, those who love Amazon are surprised to see the stock trading at more than $2,600.
In this report, we will look at stock splits, which offer a way for people to trade these stocks.
What is a Stock Split?
A stock split is a situation where a company with a high price splits the stock in a bid to attract a diverse group of investors. The most common type of stock split is a two for one, whereby the company doubles the amount of shares but then cuts the stock price into half.
Example of Stock Split
Consider a company with 100k outstanding shares and a stock price $100. This means that the firm has a market capitalisation of more than $10,000,000.
If the company wants more investors, it can slash the share price into two ($50) and then double the outstanding shares to 200,000. The market value of the firm will be the same.
A good real example of a stock split is what happened with Tesla. In 2020, Tesla announced a 5 to 1 stock split. At the time, the stock was trading at more than $2,000. Therefore, after the split, the stock started trading at about $400.
Why stock splits happen
There is one main reason why stock splits happen. First, companies announce these splits in a bid to make their share prices affordable to investors. For example, if a stock is trading at $2,000, a four-to-one split means that the shares would start trading at $500.
As a result, with the number of retail traders increasing, a split would make it possible for more people to buy the stock. This tends to boost the liquidity of the stock. However, many companies are avoiding to split their stocks because of the prestige that comes with an expensive stock.
Stock split vs reverse stock split
The difference between a stock split and a reverse split is relatively simple. A stock split happens when a company brings its stock from a high point to a lower price. A reverse stock split happens when a company decides to consolidate the number of existing shares into fewer higher priced shares. It divides the existing number of shares into a number like 5.
While calls for stock splits have been rising, more companies have decided not to do them. Most of them believe that a higher stock price is prestigious for their firms.
As such, according to data, there were only seven stock splits in the S&P 500 compared to 102 that split their shares in 1997. That is a more than 90% decline.
What happens after a stock split?
As mentioned above, a stock split happens when the share price is slashed but the outstanding shares are added. As such, for people who owns the shares, nothing major happens. The company will still have the same earnings per share.
The only benefit is that the split enables people to buy the stock at an affordable price. For example, if you have $1,000 and the stock is split from $20 to $10, it means that you can buy more shares and make more money.
However, if you are in a trade, a stock split may have a negative implication for your trade because most brokers use data provided by third parties. Therefore, some brokers may take a stock split as if the stock price of a company has dropped by 50%.
Therefore, it is always good to check out the stock split calendar before you initiate a trade. Many websites like investing.com and brokers like Fidelity offer stock split calendars.
How to trade super expensive stocks
With stock splits becoming less common, there are three main ways of trading stocks that are highly expensive.
Fractional Share Purchases
First, you can use fractional share purchases. This is a situation where a broker allows you to buy shares according to your amount.
For example, you can own a third of Amazon shares. In this case, if you have $500 and Amazon stock price is at $2,600, you can buy 0.19 shares in the company.
Second, you can use leverage. This is a situation where a broker gives you funds – like a loan to trade. For example, if you have $500 and are using a leverage of 100:1, it means that you can trade Amazon shares worth more than $50,000.
Still, while leverage is a good thing, you need to understand its risks. You can lose more money than what you have traded.
Finally, you can buy an ETF that has the company. Most of the popular ETFs tend to be relatively cheaper.
For example, in most technology ETFs, the biggest companies tend to be Apple, Amazon, and Google. Therefore, if you want to trade in Amazon, you can find the ETF with the firm as the biggest constituent.
Final thoughts: are stock splits good?
Stock splits offer an excellent way to trade shares that you would not otherwise afford. However, since they are not common among big names, you should consider using the alternatives, including leverage and fractional shares.