Have you ever wondered why companies opt for reverse splits?
It’s a strategy that reshuffles the shares of the company…
It’s like slicing a pizza differently — the same pizza, just fewer, larger slices.
But here’s the kicker: reverse splits are often a lifeline for struggling companies…
So before you get too biased thinking you should buy a big percent gainer that’s a recent split — learn why companies do reverse splits and whether you should go long or short…
Plus, see my trade idea for today in a recent reverse split … If the pattern presents itself…
Why Companies Do Reverse Splits
Before we get into why companies do reverse splits, let me give you a brief description of what a reverse split is…
A reverse split doesn’t change the value of the company. It takes the value of the company and divides it up in a different way.
Think of the company like a pizza cut up into slices. The slices are the shares.
When a company does a reverse split, it takes the pizza and recuts it into larger slices.
That means there are fewer slices (shares), and each slice is worth a bigger percentage of the company. That’s why the stock price increases.
And an increased stock price is the whole purpose of the reverse stock split…
The Nasdaq exchange has a minimum bid requirement of $1. So if a stock trades under $1 per share it’s at risk of being delisted or kicked down to the OTC market.
Companies don’t want to get kicked down to the OTC markets because nobody trades OTCs anymore.
So the reverse split is designed to help crappy companies raise their stock price and stay listed on the Nasdaq or NYSE.
Once a company does a reverse stock split it has a low float and the price increases.
These two things usually get traders excited…
I don’t like trading reverse split stocks on day one. But after the stock proves itself, there could be a trade opportunity.
But should you go long or short?
There’s no right answer.
So don’t bother getting into arguments on social media or in chat rooms with other traders…
That’s what I saw happening with Phunware, Inc. (NASDAQ: PHUN) the other day.
Some thought it was a long trade — other traders thought it was a short.
But the great thing about penny stocks is that you can trade them long on the way up. And if you have a margin account and the right broker, you can short them on the way down.
How can you tell whether a stock is on the front side of the move for a long, or the back side of the move for a short?
During the front side of a move, a stock makes higher highs and higher lows. There is usually high volume and hype that pushes the stock higher.
But as momentum fades, volume dries up and the stock starts making lower highs and lower lows.
That’s the backside of the move.
But in this market of overaggressive short sellers, stocks can rip back quickly and continue a front-side move…
So don’t get locked in on a bias either way.
Look for patterns that can show you whether a stock can go higher or if the momentum is dying.
Always have a trading plan and stick to your stops.
PHUN had a front-side move on Monday and yesterday morning it had backside price action as it made lower highs and lower lows.
But if you zoom out on the chart, the upside move is still intact. And if PHUN has a day three surge today with a breakout over $17, it could squeeze higher.
PHUN chart: 2-day, 5-minute candle — courtesy of StocksToTrade.com
If it tops out again and fails, the shorts could take over. Be ready for anything…
Have a great day everyone. See you back here tomorrow.
Tim Bohen
Lead Trainer, StocksToTrade