FAZ: What Does The Upcoming Reverse Split In A Strong Bank Rally Mean For Investors?

| About: Direxion Daily (FAZ)

What a year the banks have had. The bears have really gone into hibernation as the bulls have just pushed ahead and keep pushing the buy button. The pain for bears and many bearish funds has led to Direxion, a leader in providing popular alternative investment solutions, including leveraged bear funds, to announce on March 1, 2013, that it will execute a reverse share split of its popular 3x leveraged bear fund (NYSEARCA:FAZ).

FAZ is a unique investment vehicle which

seeks daily investment results, before fees and expenses, of 300% of the inverse of the performance of the Russell 1000 Financial Services Index.

Under normal circumstances, FAZ 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. 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. A recent notable split was the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), which underwent a 1 for 4 reverse split.

The reason for the reverse split is to make investment prices more attractive for buyers as Direxion wants to keep dollars flowing in the fund. Because the banking sector, as measured by stock performance, has been very strong in the last year, FAZ as was on a path to zero. As FAZ leverages 300% against banks, it is easy to see the fund is losing on such investments, and in turn, its shares are not only sold off by investors/traders, but also readjusted lower week after week as banks rise. With large bets against Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM) and other major components of the Russell 1000 Financial Services Index, FAZ has been crushed, down 56.5% in a year, trading at about $10.71 a share. In that same time, the Russell 1000 index is up about 20%, whereas BAC and JPM are up 50.5% and 22.6% in a year. With this performance, FAZ will soon trade under $10.00, and thus Direxion is conducting the reverse split.

It is important to note that none of the options products or holdings in BAC, JPM or other equities which FAZ management invests in will be affected by the reverse split, but some of Direxion's other products will be adjusted as well, a complete list which can be found here. The FAZ 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 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 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 pre-split share. (For example if you hold 100 shares of FAZ 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.

Reverse Splits Often Result In "Fractional Shares"

For individuals holding 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. Given that the markets are approaching all-time highs, a loss is quite possible in FAZ. While any loss or gain from a fractional share will, of course, be minimal, one way to mitigate the potentially taxable event is to purchase more shares to round out your FAZ holdings to a multiple of four, or to sell an appropriate number of shares to round out the holdings.

For Those Holding Options Contracts On FAZ?

Traders who may be holding options on FAZ should understand that this split will affect their contracts, 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 FAZ option, the option will be adjusted so that the changes in price due to the split do not affect the value of the option. The options clearing corporation automatically adjusts the price to maintain the option market.

To get an estimate of what the new FAZ option will be worth, the calculation is simple. Each FAZ option contract generally is written for control of 100 shares of FAZ 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 FAZ at a strike of $5.00. Since the split is 1 for 4 we divide $5.00 by 1/4, generating a new strike price of $20.00. 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 FAZ for $500. On your brokerage account, the contract may be adjusted to read "FAZ1" 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.

Bottom Line

FAZ is down 56% in a year, currently trading at $10.71. Investors in banks, especially BAC, have had tremendous returns in the last year. With this success, FAZ has steadily decreased. 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 four, 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 aside from 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.

Disclaimer: This article is not a recommendation to buy or sell FAZ, BAC, JPM or any other bear fund or volatility product mentioned in the article. It is for informational and educational purposes only. The options contract analysis can be applied to all splits of other companies in the future by utilizing the outlined calculations.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in JPM 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.

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