ERY: What Does The Upcoming Reverse Split Of Shares Mean For Energy Stock Investors?

| About: Direxion Daily (ERY)
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Direxion, a leader in providing popular alternative investment solutions, including leveraged bear funds, announced on March 1, 2013 it will execute a reverse share split of its 3x leveraged energy bear fund (NYSEARCA:ERY), which aims to provide a 300% return inverse to the moves in the Energy Sector Select Index. ERY management, under normal circumstances, 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 reverse split is necessary, as ERY was on a path to zero. The massively bearish bets against the major components of the Energy Sector Select Index, including Exxon Mobil (NYSE:XOM), Chevron Corporation (NYSE:CVX) and Schlumberger (NYSE:SLB) have not paid off at all in the last month, as these quality energy stocks are up 1.2%, 9.7% and 5.4%, respectively. ERY itself is down by 25.3% in a month and 35.4% in a year. Overall I regard stocks such as XOM, CVX and SLB as good buys for 2013 as many energy stocks have yet to participate in the 2013 rally. As such, ERY could drop further. To prevent it going from zero, Direxion is conducting a reverse split.

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. Recent splits include a 1 for 10 reverse split of the Velocity Shares Daily 2X VIX Short-Term ETN (NASDAQ:TVIX), the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) which underwent a 1 for 4 reverse split. Now in an effort to make investment prices more attractive for buyers, Direxion is reverse splitting the ERY as it was on a path to zero. It is worth noting that with record low volatility, the aforementioned volatility funds are again on a path to zero, and holders of these products should be prepared for another set of reverse splits.

None of the volatility products will be affected by this split, such as UVXY or VXX, but some of Direxion's other bear and bull products will be adjusted as well, a complete list of which can be found here. The ERY reverse split will be conducted at a ratio of one new share for every six 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 6 reverse split, every six pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced six times higher than the value pre-split share. (For example, if you hold 60 shares of ERY priced at $10.00 each, then after the reverse split you will hold 10 shares valued at $60.00 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.

This Reverse Split Could Result in Creation of 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 six. 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 ERY. One way to mitigate this is to purchase more shares to round out your ERY holdings to a multiple of six, or to sell an appropriate number of shares to round out the holdings.

What About Options Contracts On ERY?

For those traders who may be holding options on ERY, 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 TVIX 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 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 ERY option will be worth, the calculation is simple. Each ERY option contract is (usually) in control of 100 shares of ERY 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 ERY at a strike of $6.00. Since the split is 1 for 6, we divide $6.00 by 1/6, generating a new strike price of $36.00. The option will now cover 25 shares because we multiply 100 by 1/6. Thus, your new call option contract (which will expire on the same day as originally scheduled) will be good for a purchase of 16 and 2/3 shares of ERY for $600. On your brokerage account, the contract may be adjusted to read "ERY1" or similar and still state it is worth 100 shares at the original price, but for redemption purposes, the contract would be redeemed for 16 and 2/3 shares at the post-split price.

Bottom Line

ERY is down 35% in a year, currently trading at $5.69. 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 six, as they will be forced to sell fractional shares at a loss, or a potential gain, that could result in an annoying yet reportable 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. Energy stocks, such as XOM, CVX and SLB, which are major components of the Energy Sector Select Index, are good buys as the energy stocks have lagged the market rally overall. The reverse split of ERY demonstrates the weakness of this leveraged bear fund of late as the energy stocks have traded sideways to up of late.

Disclaimer: This article is not a recommendation to buy or sell ERY or any other bear fund or volatility product mentioned in the article. It is for informational and educational purposes only. I do however regard XOM, CVX and SLB as excellent long-term buys. 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 long position in SLB 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.