VXX: A Reverse Split Of Shares On This Volatility Product - What Does It Mean For You?

| About: iPath S&P (VXX)
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iPath, which offers a variety of ETNs, announced September 21, 2012 that it is going to conduct a reverse share split on the iPath S&P 500 short term VIX futures ETN (NYSEARCA:VXX). The VXX along with products such as the ProShares Ultra VIX Short Term Futures ETF (NYSEARCA:UVXY) and the Velocity Shares Daily 2X VIX Short-Term ETN (NASDAQ:TVIX) are popular products used to gain exposure to volatility, as measured by the CBOE VIX, which is not directly investable. Recently, UVXY underwent a 1 for 10 reverse split. Now the most popular of these products to gain exposure to VIX futures, the VXX is facing the same adjustment.

No other VIX products, such as UVXY or TVIX will be affected by this split. The VXX 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 October 4, 2012. The fund will trade at its post split price on the markets beginning October 5, 2012. The ticker symbol for the fund will not change. The fund will be issued a new CUSIP number.

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. (If you hold 100 shares of VXX priced at $5.00 each, then after the reverse split you will hold 25 shares valued at $20.00 each.) Thus, the reverse split does not change the value of a shareholder's investment. Further, the ticker symbol for the fund will remain the same. The fund 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.

Fractional Shares From Reverse Splits

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. 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 a having a potential loss on investment if prices are below where they were purchased. Given that volatility is near a five-year low, a loss is quite possible. One way to mitigate this is to purchase more shares to round out your VXX holdings to a multiple of four, or to sell an appropriate number of shares (preferably on an up day) to round out the holdings.

For Those Holding Options Contracts On VXX

For those traders who may be holding options on VXX, this split will affect your contract, albeit minimally. Once iPath conducts the reverse split, the contract undergoes an adjustment that is commonly known as "being made whole", which means the option contact 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 VXX 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 VXX option will be worth, the calculation is simple. Each VXX option contract is (usually) in control of 100 shares of VXX at some predetermined strike price. To find new the 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 VXX 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 VXX for $20.00.

Bottom Line

This reverse split will truly only 'hurt' investors who own common shares at a total that is not a multiple of 4, as they will be forced to sell fractional shares at a loss, or a potential gain, that could results 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.

Disclaimer: This article is not a recommendation to buy or sell VIX futures through VXX, UVXY, TVIX or any other volatility product. It is for informational 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, 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.