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, 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 3x leveraged bear fund, the Direxion Daily 3X Real Estate Bear ETF (NYSEARCA:DRV), which aims to provide a 300% return inverse to the moves in the Real Estate Index. This split continues a line of reverse splits in bearish funds in the last few months. As real estate has been one of the stronger points of this bull market and is one of the few sections of the economy that has been bright in this weak recovery, DRV has suffered extensively. The Dow Jones Real Estate Index (NYSEARCA:IYR) is only up 6% in 2013 and yet DRV is now down 33% year-to-date and is down over 50% from its 52-week high. The IYR was up another 12% from its current level in May, but when interest rates rose, the housing market was pressured temporarily. This action helped DRV bounce a bit off its 52 week low of $11.28. The market action has since stabilized in IYR and DRV, and as such, in an effort to make investment prices more attractive for buyers, Direxion is reverse splitting the DRV 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 DRV Reverse Split Will Take Place And What Will Happen to Your Position
No other real estate ETF products will be affected by this split, such as IYR, but some of Direxion's other products will be adjusted as well. The DRV reverse split will be conducted at a ratio of one new share for every four 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 4 reverse split, every four pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced four times higher than the value of the pre-split share.
For example, if you hold 100 shares of DRV priced at $10.00 each, then after the reverse split, you will hold 25 shares valued at $40.00 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.
The DRV Reverse Split 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 four. 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 DRV right now. One way to mitigate this fractional share issue is to purchase more shares to round out your DRV holdings to a multiple of four, or to sell an appropriate number of shares to round out the holdings.
What I Recommend For Those Holding DRV 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. As such, these funds really are trading vehicles in many respects; 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 DRV into the reverse split, is that the new price may attract new investment dollars compared to its current sub $15 pre-split price tag. While I again point to the risk of holding these for an extended period due to the rebalancing daily of the holdings, for those holding options, there are special considerations.
What About Options Contracts On DRV?
Considering what will happen to options on this ETF is important. For those traders who may be holding options on DRV, 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 DRV 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 DRV option will be worth, the calculation is simple. Each DRV option contract is (usually) in control of 100 shares of DRV 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 DRV at a strike of $10.00. Since the split is 1 for 4 we divide $10.00 by 1/4, generating a new strike price of $40.00. The option will now cover 25 shares because we multiply 100 by 1/4. Thus, your new call option contract (which will expire on the same day as originally scheduled) will be good for a purchase of 25 shares of DRV for $1,000.
On your brokerage account, the contract may be adjusted to read "DRV1" or similar and still state it is worth 100 shares at the original price, but for redemption purposes, the contract would be redeemed for 25 shares at the post-split price. But should you hold these options on the real estate index into the reverse split?
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.
DRV is down 33% in 2013, currently trading at $14.02. 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 that when totaled, is not a multiple of four, 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 $15 dollar price DRV carries now. Seeing as the bull market just keeps raging on and housing took a brief breather already from May to July, as the IYR dropped over 10%, I cannot recommend a buy on this ETF heading into the split.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in IYR over 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.