How To Trade The Upcoming Reverse Split In The Leveraged S&P 500 Fund SPXS

| About: Direxion Daily (SPXS)

The bull market of the last few years continues to stampede ahead in 2013. The Dow Jones Industrial Average ETF (NYSEARCA:DIA) and the SPDR S&P500 ETF (NYSEARCA:SPY) are up 18.7% and 18.5%, respectively. This bullish action has caught many bears in a trap, forcing them to cover shorts for substantial losses, furthering the bull market buying. Some bearish funds have been decimated because of this action. Direxion, who is a leader in providing popular alternative investment solutions, including leveraged bear funds, announced on July 24, 2013 it will execute a reverse share split of its popular 3x leveraged bear fund, the Direxion Daily 3X S&P 500 Bear ETF (NYSEARCA:SPXS), which aims to provide a 300% return inverse to the moves in the S&P 500 Index. This split continues a line of reverse splits in bearish and volatility funds in the past few months, as the 4 year bull market continues to power higher with low volatility. Recently, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) underwent a 1 for 4 reverse split, and the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) underwent a 1 for 10 reverse split. A few months ago the Direxion Daily 3x Small Cap Bear ETF (NYSEARCA:TZA) underwent a 1 for 4 reverse split as well. Now in an effort to make investment prices more attractive for buyers, Direxion is reverse splitting the SPXS as it was slowly on a path to zero. The justification is the same as most other reverse splits; that the post-split investment prices will be more attractive for buyers.

When The Reverse Split Will Take Place And What Will Happen to Your Position

None of the volatility or leveraged bearish products aforementioned will be affected by this split, such as UVXY, VXX or TZA, but some of Direxion's other products will be adjusted as well. The SPXS reverse split will be conducted at a ratio of one new share for every five held. The reverse split will apply to shareholders of record as of the close of the markets on August 19, 2013 and will begin trading at the adjusted price August 20, 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. (For example if you hold 100 shares of SPXS priced at $10.00 each, then after the reverse split you will hold 20 shares valued at $50.00 each.) Thus, the reverse split does not change the value of a shareholder's investment. Again, the ticker symbol for the fund will remain the same even with the new change in price. The only change on paper for the fund is that it will be issued a new CUSIP number, which identifies the product on exchanges.

There are two more considerations to think about during this split. What happens with fractional shares, and what happens to owners of options contracts.

Reverse Splits Could Result in Fractional Shares

For those shareholders who hold quantities of shares that are not a whole number with an exact multiple of the reverse split ratio, the reverse split will result in the creation of a fractional share. This will 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 weeks post-split. The major issue associated with such a move is that it forces shareholders to realize either gains or losses, which could result in a taxable event for those shareholders, in addition to having a potential loss on investment if prices are below where they were purchased. Granted, this is more of an annoyance than any kind of meaningful financial impact, however, it is relevant and needs to be mentioned. Furthermore, given that the markets are at all-time highs, a loss is pretty much guaranteed in SPXS right now. One way to mitigate this fractional share issue is to purchase more shares to round out your SPXS holdings to a multiple of five, or to sell an appropriate number of shares to round out the holdings.

What I Recommend For Those Holding Common Stock.

First, I have cautioned on the risks of holding these 3X leveraged funds for extended periods of time in the past. This is mainly because of the nature in which these funds invest and are re-weighted daily. The main issue is dealing with what is known as contango with these products. A thorough description of this issue can be found here. Thus, these funds really are a trading vehicle in many respects that you can make a quick profit on in a couple of days or weeks. To be profitable over a several month period, we would really need a sustained bear market. That being said, summer is generally weak, especially in August. Thus, those holding common shares probably have small losses given we have closed up 5 weeks in a row overall in the markets. However, we are due for a breather. What helps make the case for owning some SPXS into the reverse split is that the new price may attract new investment dollars compared to its current sub $10 pre split price. While I again caution the risk of holding these for an extended period

What About Options Contracts On SPXS?

Considering what will happen to options on this ETF is important. For those traders who may be holding options on SPXS, this split will affect your contract, albeit minimally. Once Direxion conducts the reverse split, the contract undergoes an adjustment that is commonly known as "being made whole", which means 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 SPXS option, the option will be adjusted so that the changes in price due to the split do not affect the value of the option.

So if there is no positive or negative effect on the option value, just how much will the option be worth post-split? You actually don't need to worry about such things, because the options clearing corporation automatically adjusts the price to maintain the option market. However, for those who want an estimate of what the SPXS option will be worth, the calculation is simple.

Each SPXS option contract is (usually) in control of 100 shares of SPXS 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 SPXS 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 will expire on the same day as originally scheduled) will be good for a purchase of 20 shares of SPXS for $500.

On your brokerage account, the contract may be adjusted to read "SPXS1" 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.

What I Recommend For Options Holders

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. But there is on important caveat that I have detected with reverse splits. Specifically, I want to caution options holders that after the split, although you may hold a legitimate option deliverable for a certain number of shares, the volume will drop off dramatically in trading on the option shortly after the split. The effect of this is that it often leads to exceptionally wide bid/ask prices. This becomes especially true once new contracts are written that are at or near the new common share trading price. Therefore, Options holders may want to trade out of these positions for this reason. Considering this is being done because we are in a bull market, anyone holding call options is likely underwater. Those holding puts may be safe to hold given the recent price action trend downward. However, I would look to get out of the option position pre-split.


SPXS is down 45% in a year, currently trading at $9.27. To bring the product to an investment price that Direxion believes is more attractive, 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 small but annoying 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. Options holders may want to trade out of these positions as bid/ask spreads widen and volume dries up. While the overall investment value does not change from this reverse split for those holding common shares, the only benefit is that a higher share price may attract new money, compared to the sub $10 dollar price SPXS carries now. Seeing as the bull market just keeps raging on, I cannot recommend a buy on this ETF heading into the split, however, the split may attract new investment dollars.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.