In early August, I wrote about how shares of T2 Biosystems (NASDAQ:TTOO) could rise to $1 or more in a short-term frenzy. Meme investors had singled out the stock, and heavy options trading meant shares were at risk of getting squeezed.
Retail investors delivered. Within two weeks, TTOO’s stock had risen from 30 cents to 63.5 cents, a stunning 110% return. Many options holders were rewarded with even more significant gains.
The party, however, is ending. On Sept. 12, TTOO’s shareholders will vote on a proposal to allow a reverse split in a ratio between 1-for-50 and 1-for-150. And if the proposal is approved (and enacted!), short-sellers will likely pounce on the stock and create a downward spiral.
Investors should beware. The fun is over for TTOO stock… at least for now.
TTOO Stock: Beware the Reverse Split
Most reverse splits are done out of necessity. The Nasdaq Stock Exchange requires companies to maintain a $1 minimum share price, and firms that fail to meet that target risk getting de-listed. Companies thus often reassign values to their stocks. In a 1-for-100 reverse split, for instance, every 100 shares is combined into a single issue. All else equal, that raises the stock price 100-fold.
Yet, changing decimal points on a stock has some significant side effects.
The most obvious issue is that the action will force some small shareholders out of their positions. Most reverse splits offer no fractional shares, and T2 Biosystem plans to forcibly sell off any rounding errors. That means any shareholders who own less than $45 of shares could see their entire stake liquidated. (This assumes a 1-for-150 reverse split where a shareholder owns 149 shares.)
Reverse splits are also a sign of corporate weakness. Studies have shown that firms undergoing a reverse split tend to underperform the market by -22.7% over the next three years. That makes it one of the most potent sell signals on the market.
A Potential Bear Raid
However, the most worrying issue for T2 Biosystems is the sudden selling pressure during the weeks after the split.
Consider the average short-seller. These market pessimists are constantly worried about blowing up their portfolios on a bad bet, so they mostly avoid sub-$1 stocks that can rise 2x… 5x… or more. T2 Biosystems itself only has 9.43% of its floated shares sold short.
But higher-priced stocks tend to be less volatile, making them more attractive to short-sellers. According to data from Thomson Reuters, the average price of the 50 most-shorted companies in the Russell 3000 Index is $25.80. Only two companies on that list have share prices below $2, and none trade below $1. Similarly, doubling a company’s share price reduces its relative volatility by 52%.
Higher share prices also make stocks more attractive to bearish options traders. Strike prices are only available to the nearest half-dollar, so shares must trade well above 50 cents to offer attractive returns. The most any investor can make from buying TTOO puts today with September expirations is roughly $9 for every $20 wagered — a terrible risk-reward payoff.
That means a reverse split in TTOO’s stock will suddenly turn it into a short-selling bonanza. Traders know that these events tend to create selling pressure, and T2’s potential $45-per-share price will make it far easier to short and open bearish options positions. A downward gamma squeeze might even happen.
Lessons From Mullen and AMC
This isn’t the first time a meme stock has fallen after a reverse split. In May 2023, Mullen Automotive (NASDAQ:MULN) fell 35% after it performed a 1-for-25 split. A similar collapse happened with AMC Entertainment’s (NYSE:AMC) 1-for-10 action last month. Between Aug. 24 through Sept. 11, shares lost 50% of their value while open interest on bearish options spiked. No fewer than 150,000 put options now bet AMC’s shares will close below $5 by Sep. 15.
T2 Biosystems will likely see a similar drawdown (at least without positive FDA news). The company is popular among retail traders, and a sudden price decrease will cause many to lose interest. That will increase selling pressure, further decrease interest, and so on.
The company could even go bankrupt. T2 received no contribution BARDA research contribution revenues last quarter, which means that it’s $16 million of remaining cash could run out by the end of the year. Falling share prices will make at-the-market offerings more difficult.
Of course, there’s still hope for the firm. T2 Biosystems has four medical devices undergoing FDA approval — any one of them could turn into a multi-million-dollar business. The company has also managed to survive over a decade as a profitless entity.
But investors have plenty of better short-term options. Last month, I noted that “no competitor found T2 an attractive acquisition, even as its market capitalization bordered on zero.” Its lenders also appear to be losing patience; in July, management increased TTOO’s share count 13x to satisfy a $10 million debt-to-equity deal.
That makes T2’s stock risky at best. Buyer beware, the catalysts for a drawdown are all here.
As of this writing, Tom Yeung did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.