Consolidation of shares is a corporate action where a company reduces the number of outstanding shares by combining the shares and increasing the face value. This is also known as a reverse stock split. The company notifies the shareholders through email before the stock consolidation.
By decreasing the quantity of shares, the individual value of each share is increased. However, the reduction in the quantity of shares held will not have a negative impact on the shareholders or alter the ownership percentage.
Why do companies consolidate shares?
When a company consolidates its shares, it reduces the total number of shares held by existing shareholders. This is done to change the capital structure or attract investors. By reducing the number of shares, the value of each share increases, making the shares more appealing to investors. The consolidation of shares is also known as a reverse stock split.
How to identify stocks under consolidation?
To recognise stocks undergoing consolidation in the Indian stock market, pay attention to the following indicators on a price chart:
1. Steady support and resistance levels
Look for stocks that exhibit well-defined and consistent support and resistance levels on the price chart. Similar to a flag continuation pattern, these levels suggest that the stock may be undergoing consolidation.
2. Narrow trading range
Stocks in consolidation often demonstrate a narrow trading range. This means that the price fluctuates within a confined range, indicating a period of stability or indecision in the market.
3. Low and consistent volume
Check the volume of the stock during the consolidation phase. Stocks in consolidation typically experience low and consistent trading volumes without significant spikes. This contrasts with stocks involved in more active trading or those experiencing sudden price movements.
Identifying these three properties on a price chart can help investors recognise stocks that are currently undergoing consolidation in the Indian stock market. It is important to note that consolidation periods are characterised by a temporary pause in the stock's trend, providing valuable insights for investors to make informed decisions based on the market's current state.
How consolidation of shares works
Consider Ms. B, who currently holds 8,000 shares in company ABC at a face value of Rs. 15 each. In the case of a share consolidation with a ratio of 1:4, where 4 old shares are consolidated into 1 new share, the following changes occur:
1. Original holding
- Ms. B initially holds 8,000 shares at Rs. 15 each.
- Value of holdings before consolidation: 8,000 × Rs. 15 = Rs. 1,20,000
2. Consolidation process
- With a consolidation ratio of 1:4, every 4 old shares are consolidated into 1 new share.
- Ms. B's 8,000 shares are consolidated, resulting in 2,000 new shares (8,000 ÷ 4).
- The face value of each consolidated share is now Rs. 60 (Rs. 15 × 4).
3. After consolidation
- Value of holdings after consolidation: 2,000 × Rs. 60 = Rs. 1,20,000
While the number of shares held by Ms. B has reduced from 8,000 to 2,000 due to the consolidation (1:4 ratio), the overall value of her shareholding remains the same at Rs. 1,20,000. The consolidation process increases the face value of each share while decreasing the quantity, maintaining the total value of the investment.
How to trade in consolidation?
Here’s a concise guide on how to trade in consolidation:
1. Reduce trading limit
In a consolidation phase, market movements may become less predictable, and the risk of sudden price swings may increase. To mitigate potential losses, consider reducing your trading limit during consolidation. This cautious approach helps safeguard your capital and ensures you are well prepared for any unexpected market fluctuations.
2. Select spreads instead
Instead of engaging in direct stock trading, consider using spread strategies during consolidation. Spreads involve simultaneously buying and selling options or futures contracts with different strike prices or expiration dates. This approach can provide a level of protection by minimising the impact of price volatility on your trades. Options strategies such as iron condors or credit spreads may be particularly suitable in consolidating markets.
3. Increase prudence level
Consolidation periods often signal a market in indecision or awaiting a significant catalyst. During such times, it is crucial to increase your prudence level and avoid making impulsive decisions. Conduct thorough technical and fundamental analysis before entering trade and be attentive to any news or events that could impact the stock. Patience and careful consideration are essential when trading in consolidating markets.
Example: Imagine company PQR is currently undergoing consolidation, and you are considering trading its stock. Instead of executing a standard buy or sell order, you might opt for an options strategy. Let us say you choose to implement an iron condor by simultaneously selling an out-of-the-money put and call while buying further out-of-the-money put and call options. This strategy allows you to profit from low volatility within a specific price range while limiting potential losses.
Benefits of share consolidation
Here are some of the key benefits of share consolidation:
1. Attracting potential investors
Consolidating shares can enhance a company’s appeal to prospective investors. The company can make its stock more attractive to investors by decreasing the total number of outstanding shares, which would result in an increase in the per-share value.
2. Meeting stock listing requirements
To comply with the stock exchange listing requirements, some companies may need to meet the minimum price requirements for their listed stocks. Share consolidation can help companies achieve this goal by increasing the per-share value.
3. Avoiding major exchange actions
If a company’s stock price falls below the minimum price required by the stock exchange, the exchange may take action against the company, such as delisting the stock. Share consolidation can help companies avoid such actions by increasing the per-share value.
4. Safety measures
Share consolidation can help companies protect their shareholders from the risks associated with low-priced stocks.
Consolidation trading strategy: breakout and breakdown
Here’s how to implement a breakout and breakdown strategy:
1. Breakout strategy
A breakout occurs when the stock price surpasses a well-defined resistance level, signalling the end of consolidation and the potential beginning of a new trend. Traders employing a breakout strategy may initiate trades in the direction of the breakout, anticipating a significant price movement. Confirmation through increased trading volume often strengthens the validity of a breakout.
2. Breakdown strategy
Conversely, a breakdown happens when the stock price falls below a clearly defined support level, indicating a potential end to consolidation and the onset of a new trend in the downward direction. Traders employing a breakdown strategy may consider short-selling or adopting bearish positions to capitalise on the anticipated downward movement. Similar to breakouts, increased trading volume can enhance the reliability of a breakdown.
Conclusion
In conclusion, understanding how to navigate and trade during consolidation periods is essential for investors seeking to optimise their strategies in varying market conditions. Share consolidation alters the structure of shareholding without affecting the total value of investments, and traders can adapt by reducing limits, employing spread strategies, and exercising prudence.
Successful trading in consolidation requires a combination of strategic planning, risk management, and adaptability. By staying informed about market conditions, employing appropriate trading strategies, and adjusting your approach as needed, you can enhance your ability to make informed decisions and navigate the complexities of consolidation with confidence.
