Technology stocks have had an interesting 6 months. As we all know by now, the one-time loved Apple (NASDAQ:AAPL) has fallen from grace with investors, declining over 35% from its highs of $705. Meanwhile, Google (NASDAQ:GOOG) has become the tech stock of choice, recently hitting an all time high of $844. In the last 6 months, AAPL has declined 37%, while GOOG is up 15%. The uptrend in GOOG is not unique, as many tech stocks are up in the last few months as stocks have continued to see inflows.
One of the best trading vehicles for short to medium-terms selloffs in the tech stocks, the Direxion 3X Daily Technology Bear ETF (NYSEARCA:TECS), has seen a 33% loss in the last year. TECS as an investment seeks "daily investment results, before fees and expenses, of 300% of the inverse of the performance of the Technology Select Sector Index. Under normal circumstances, TECS management creates short positions by investing at least 80% of its assets in financial instruments that, in combination, provide leveraged and unleveraged exposure to the index." The index that TEC shorts includes computers and peripherals companies, software, diversified telecommunications services, communications equipment, semiconductors and semiconductor equipment, internet software and services, IT services. Both AAPL and GOOG have quite large weightings of this index.
Given the appreciation in tech stocks and the depreciation in TECS, Direxion announced on March 1, 2013, it will execute a reverse share split of TECS. Other leveraged bearish and volatility funds have reverse split in the past few months as the 4 year bull market continues to power higher, such as the 1 for 4 reverse split of the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). TECS has sold off as the components of the Technology Select Sector Index have had a huge bullish run (save AAPL). Highlighting the strength the tech stocks in the space have had, Direxion believes that TECS post-split investment prices will be more attractive for buyers. No other technology index fund will be affected by this split, such as (NYSEARCA:XLK), but some of Direxion's other products will be adjusted as well, which are detailed here. The reverse split will be conducted at a ratio of 1 for 5 and will apply to shareholders of record at the close of the markets on April 1, 2013, and will begin trading at the adjusted price April 2, 2013. The ticker symbol for the fund will not change. The reverse split will increase the price per share of the fund with a proportionate decrease in the number of shares outstanding. In a 1 for 5 reverse split, every five pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced five times higher than the value of the pre-split share. The following example best illustrates what to expect: If you hold 1000 shares of TECS priced at $10.00 each, then after the reverse split you will hold 200 shares valued at $50.00 each. As you can see, the reverse split does not change the value of a shareholder's investment, it still remains $5,000.
One consideration is shareholders who have quantities of shares that are not a whole number with an exact multiple of the reverse split ratio will be left with what is known as a fractional share. A fractional share will be created and affect any shareholder who does not hold a number of shares that is a multiple of five. After the reverse split occurs, fractional shares will be redeemed for cash and sent to your broker of record, generally within two to three weeks post-split. One issue to consider in this event is that redemption of fractional shares forces shareholders to realize either gains or losses, which could result in a taxable event in addition to having a potential loss on investment if prices are below where they were purchased. Given the run in tech stocks, with the exception of AAPL, a loss is a strong possibility with TECS. To avoid this scenario, investors can purchase more shares to round out their TECS holdings to a multiple of five, or to sell an appropriate number of shares to round out the holdings.
Options contracts are an important consideration as well. Traders who may be holding options on TECS should realize that this split will affect your contract(s), albeit minimally. Once Direxion conducts the reverse split, the contract undergoes an adjustment referred to as "being made whole." When contracts are adjusted to be "made whole," it simply means that the option contract is modified accordingly so that options holders are neither negatively nor positively affected by the split. While we know the reverse split will adjust the price of the underlying shares of the TECS options, the options will be adjusted so that the changes in price due to the split do not affect the value of the options. The options clearing corporation will automatically adjust the price of all existing contracts to maintain the option market.
For those who want an estimate of what their current TECS option will be worth, the calculation is simple. Each TECS option contract is (usually) in control of 100 shares of TECS at some predetermined strike price. To find the new share coverage of the option after the split, all you do is simply take the split ratio and multiply by the old share coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio. Let's look at an example of a call option contract for 100 shares of TECS at a strike of $5.00. Since the split is 1 for 5 we divide $5.00 by 1/5, generating a new strike price of $25.00. The option will now cover 20 shares because we multiply 100 by 1/5. Thus, your new call option contract which still expires on the same day as originally scheduled will be good for a purchase of 20 shares of TECS for $500. On your brokerage account, the contract may be adjusted to read "TECS1" or similar and still state it is worth 100 shares at the original price, but for redemption purposes, the contract would be redeemed for 20 shares at the post-split price.
In conclusion, we are continuing to see strength in many tech stocks, led by GOOG. Meanwhile, AAPL continues to struggle to find a bottom, though it seems to have bounced off the $420 level a few times. With the tech sector showing strength overall, this reverse split for TECS is deemed necessary by Direxion to prevent it from heading to zero. TECS is down 33% in a year, currently trading at $7.89.
TECS is a short-term play in general given its leveraged nature. Thus I do not recommend a buy and hold on this or any other leveraged fund. However, to bring the product to an investment price that Direxion believes is more attractive to investors, it is conducting this reverse split. The reverse split of shares only really negatively impacts investors who own common shares at a total that is not a multiple of five, as they will be forced to sell fractional shares at a loss, or a potential gain, that could result in a taxable event. Owners of options contracts will not be affected besides being faced with owning a new contract at a different strike price for a different number of shares. The total value of the contract will, however, remain the same.
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.