What Happens to Your Options When a Company Goes Bankrupt?

11/05/2009 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Ford Motor Co (NYSE: F) has gone from needing a government bailout to reporting a billion-dollar profit, while at the same time, CIT Group (NYSE: CIT) announced a pending bankruptcy. Distressed companies present interesting and dramatic opportunities, as well as risks. Some of these are particularly important for options traders.

There is a lot of talk right now about taking some long bets on some of these near-bankrupt stocks. The potential for upside is appealing. After all, how much farther can they go down? But what happens to a stock or option when a company goes into bankruptcy?

If the company goes into liquidation (one of the potential results of the bankruptcy process), all its assets will be gone before common shareholders or option holders get any money. However, if the company reorganizes within bankruptcy, shareholders may still be able to walk away with some value at the end of the process, while option traders are still likely to get nothing.

This is so because most calls and puts are options on common stock. A common stock shareholder is usually in last position during liquidation. If a company's assets are going to be liquidated in a bankruptcy, the secured lenders will be paid first, anything left over (usually nothing) will go to preferred shareholders, and finally, common shareholders get the remnants. It is extremely unusual for the common shareholders to get anything.

To make matters worse for option traders, when a company seeks bankruptcy protection, trading in its stock is typically halted. The liquid market for its shares dries up and option buyers may be left holding a worthless asset. If there is no market for the stock and expiration day passes, the option will expire worthless. Option writers, on the other hand, could walk away with the entire premium. In the video, I will go into more detail of what happens to an option when trading is halted.

The real takeaway from this article is not that aggressive traders should not be buying and selling these stocks and options on them, but that they need to appreciate the risks associated with a company on the verge of bankruptcy. These risks are not isolated to just whether the company can emerge from bankruptcy. The risk of an illiquid market forcing all its options to expire worthless must also be accounted for.

I also refer to a document called "Characteristics and Risks of Standardized Options," published by the Options Clearing Corporation. You can get a copy of that document for yourself here.

By John Jagerson of LearningMarkets.com

Find a video with more details by visiting LearningMarkets.com here.

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