Occasionally a well known company will announce a stock split and the news goes viral. The share price may rocket on the headline, there'll be a lot of excitement on social media and all sorts of newbies will be asking if they should jump in. It's important to understand what a split actually is and what it isn't so that you don't get caught up in the noise.

A stock split is when a company increases the number of its shares and reduces the price per share by the same proportion. In a 2 for 1 split each shareholder gets two shares for every one they owned and the price is cut roughly in half. If you owned 10 shares at $ 200 you'd end up with 20 shares at about $ 100. Your total value is the same, $ 2,000 before and after. The company isn't worth any more or less as a result of the split. The pie is the same size, it's just been cut into more slices.

Splits come in all sorts of sizes. The most common are 2 for 1, 3 for 1, 4 for 1 and 10 for 1. A few companies have gone much bigger. There's also a reverse split where the company reduces the number of shares and increases the price. A 1 for 10 reverse split would see 10 shares become 1 and the price go up 10 fold. Total value is of course unchanged at the time of the split.

So why do companies do it? It's primarily about accessibility. If the share price is up into the hundreds or thousands it can seem a bit out of reach for the average investor (despite the fact that a lot of brokers now allow fractional shares). A lower share price can make the stock look much more accessible and it can also make it easier for employees to buy shares via their stock plans. Splits also make options contracts more flexible as options are generally on 100 shares and a lower share price means a smaller contract cost.

Why does the stock often go up at the announcement? There's no single answer and the evidence is mixed. Some studies have found that stocks do tend to do well following a split, though that may be down to the fact that companies tend to split after a long period of growth (i.e. after the stock has been on a run up). A split can be a signal of management confidence and it can bring in new buyers. It doesn't in any way change the business. If the stock goes up purely as a result of the split announcement then that enthusiasm will probably dissipate quite quickly.

Reverse splits are a different matter entirely and require a degree of caution. They're frequently undertaken when the share price has fallen right down to the point where it's very low indeed (sometimes just to avoid being delisted from the exchange due to being below the minimum price). That makes a reverse split a fairly strong indicator of a company that's in trouble. The stock will often fall again after a reverse split (though that's by no means a given). If you see one, you need to look carefully at the reason the company required it before you jump to any conclusions.

What does this mean for your charts? Your charting platform should adjust the historical prices for splits so that the chart is continuous. Without that adjustment a 2 for 1 split would appear on the chart as a 50% crash. Make sure that adjustment is turned on as it will impact your moving averages, your support levels and any pattern you're attempting to read.

Your open orders count as well. If you're holding a stock at the time of a split your broker will automatically adjust your shares and cost basis. Stop loss and limit orders can be very different depending on the broker. Some will adjust them, some will just cancel them. It's worth checking your broker’s policy and looking at your open orders on the day of the split.

For swing trading you treat a split as a piece of news rather than a setup. Ask yourself the same questions you would ask about any catalyst. Is the stock in an uptrend? Is volume strong? Is there a clear entry and stop? A stock that's already run up a lot into the split announcement may be extended and chasing it is a very risky proposition. You'd want to wait for a pullback or a proper base as you would in any other situation.

The bottom line is it's a split which changes the price, not the value of the company. Look at the chart, look at the trend, look at the business and let the split headline be a catalyst to look at it more closely rather than a reason to buy.