Adjustment in Stocks & Indices: What Every Trader Must Know About Price Corrections

An adjustment or price correction is applied whenever companies make cash payments called dividends, stock splits, or participate in other corporate actions. The understanding of adjustments is more than technical knowledge. It is vitally important to anyone wanting to assess market data correctly. 

Another way to think of it. Suppose a company pays a $2 per share dividend. In that case, the share price automatically drops $2 on the ex-dividend date. Your total value has not changed. You still have the same value, just divided between stock price and cash received. It is the same as approaching a store and receiving a gift card to that store. Nothing has changed in terms of your spending power, but your method of holding it is different. 

Types of Stock & Index Adjustments You Must Know

Dividend Adjustment: This adjustment occurs when a company makes a distribution of profits to shareholders. On the ex-dividend date, the stock price will adjust down by the dividend amount. Think about this like earning interest on your savings account. Your wealth, in total, has not changed, but now you have an account with some principal and some interest. Microsoft pays dividends on a routine basis, and every time they do, the price adjustments happen automatically, keeping the historical information intact.  

Stock Splits and Reverse Stock Splits: This type of action changes the number of shares, but does not change the value of the company. In a stock split, one share is split into multiple shares at the same proportionally lower price. This is like cutting a cake into more slices. You still have the same cake, but it is cut into smaller pieces. Tesla's 2020 split was famous because it was a 5-for-1 split. 

How Adjustments Affect Trading Strategies

Technical analysis relies entirely on historical price information. When using unadjusted data, the indicators might provide false signals. Support and resistance levels change. Moving averages can provide incorrect crossover signals. Trendlines can break where they shouldn't.

This is significant specifically at the back-testing level for professional traders. Imagine testing a trading strategy in the S&P 500 using unadjusted historical data. You could base an entire backtest on "buying" just prior to when the stock pays dividends with returns represented that in reality did not exist from your backtest. The strategy with this approach would likely fail spectacularly in live trading.

Impact of Adjustments on Portfolio and Risk Management

Adjustments to readings are extremely important for portfolio and risk management. Portfolio calculations are based on accurate price readings, and whenever a stock adjusts due to a split, reverse-split, mergers, etc. the price reading will go down, but your total asset value is unchanged. However, the new stock price is adjusted for your position weights and allocating adjusted prices.

Consider holding a portfolio with equal weight in ten stocks, and then running into a situation where one stock has a 2-for-1 split. This stock's price is now half of what it used to be (disregarding the many other factors which impact a stock's price). If you calculate your portfolio weights using your raw prices rather than adjusted prices, you will think this position has decreased in weight when, in fact, it has not. The actual allocation does not change. 

How to Access and Apply Adjustment Data on Trading Platforms

While modern trading platforms make it easy to make adjustments, you must know where the adjustments are located. Most price data feeds on platforms like Tradewill, TradingView, and MetaTrader will make automatic adjustments in their price data feeds. 

The main thing to know is the difference between "Close" price and "Adjusted Close" price. A "Close" price tells you what a stock actually traded on that day. An "Adjusted Close" price tells you what that price would be worth today with all subsequent actions by a company factored in. 

Apply Adjustments to Improve Your Trading Accuracy

Knowing adjustments distinguishes traders who guess from traders who know. These price adjustments are not hidden, technical details. Adjustments are absolutely essential to confident, accurate historical analysis; trustworthy technical signals; valid backtesting; and sound portfolio management.

Whenever you analyze a chart, calculate returns, or test a strategy, you are either explicitly or implicitly relying on adjustment information. While modern platforms often automate much of this adjustment work, having an idea of what is going on behind the scenes will help you avoid the traps facing uninformed traders.

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