Bankruptcy and Options

Hat Tip   Top hat   to kbluck for suggesting this topic.

With General Motors (GM) facing bankruptcy this weekend, this is a suitable time to discuss what happens to the options, when the underlying company declares bankruptcy.

It's traditional for existing shareholders to lose 100% of their investment when a company becomes bankrupt, even when there are assets of value.  Stockholders are at the end of the line, and those assets go to others.  Think of K-Mart.  After their bankruptcy, it was suddenly 'discovered' that their real estate was worth a great deal of money and the 'new' K-Mart stock soared.  The original shareholders were left with nothing.

Call options are kaput

Once bankruptcy is declared, the stock is worthless, as are all call options. The stock is usually delisted from the stock exchanges, but  continues to trade in the OTC (over the counter) market.  If you wonder why it trades and why anyone would pay anything for the shares, those are good questions. 

Anyone who is short stock has won his/her wager.  But the short position remains in the investors account.  The easiest way to eliminate that position is to buy the shares.  Thus, assuming the broker cooperates and charges a minuscule fee, it pays for investors to pay a small fraction of one penny per share – just for the convenience of exiting the position.  If you are short stock, try to negotiate a low commission for covering those shares.

Put options are golden

Put options become worth the value of the strike price, and that's the maximum possible value they can attain.  In other words, the GM Jul 2 put is worth $2 (or $200 per contract).  All time value is lost, and every put with a strike price of 5 is worth $500. 

Assuming GM options continue to trade, there's very little chance you can sell puts at their full value, because there is no incentive for anyone to pay that price – there is nothing to gain for the person who buys your options.  Thus, you can anticipate that the bid will be less the option's full value.  Put owners don't have to accept that bid; they can offer at any price they choose – but be reasonable and don't ask for more than the strike price.

Keep in mind that for every option bought, an option is sold.  Thus, it's possible that some investor who is short puts may be willing to pay the full intrinsic value for the convenience of eliminating the position from his/her account.  Don't count on being able to find such a buyer.  The only incentive for buying the options prior to expiration is to buy the puts for less than they are worth.

If you are willing to accept a penny or two less than full value, you probably can sell your puts.  But because the stock is worthless, those who own shares are often willing to accept 'anything' for them.  Thus, you may be able to buy shares at a small fraction of one penny per share.  If you can do so, and if the cost of commissions doesn't raise the price too high, buy stock (100 shares per put) and then exercise the puts.  This is one of those rare situations in which it may be better to exercise than sell the options.

A put owner doesn't have to do any of those things and is entitled to wait until the options expire – and then buy stock (if price is low enough) to cover the short position.   However, there's no reason to wait for expiration to convert your options to cash.

*** IMPORTANT***  The OCC (Options Clearing Corp) 

I have not yet been able to verify this, but when I called the OCC, the person with whom I spoke informed me that a recent rule change covers these situations.  He said that when a company is bankrupt, the stock is declared 'dead' and all ITM options (obviously no calls are ITM) are cash settled.  That means there is no need either to sell the puts or buy the stock.  You can exercise and collect full value for the puts.  That's good news for put owners – but before you act on this 'fact' – please ask your broker, an options exchange, or the OCC if these options are indeed cash settled.

I will update this post, if and when I can verify that the options are cash settled.

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10 Responses to Bankruptcy and Options

  1. kbluck 05/30/2009 at 10:57 AM #

    > if and when I can verify that the options are cash settled.
    OCC bylaws and rules: http://www.optionsclearing.com/publications/bylaws/bylaws.jsp
    In the bylaws, I believe the relevant section for adjusting stock option contracts to cash exercise due to corporate actions affecting the underlying stock is Article VI, Section 11A.
    Also, according to OCC Rule 807, in such cases the expiration date will ordinarily be accelerated as well.

  2. Mark Wolfinger 05/30/2009 at 12:00 PM #

    Thanks, but I cannot find the reference.
    Do you have a page number in the bylaws?

  3. kbluck 05/30/2009 at 2:07 PM #

    p. 74, ‘Adjustments for Stock Option Contracts’.
    However, I think it only applies when a stock issue quits trading altogether, as in a merger, liquidation, or dissolution. I would expect that as long as the stock continues trading OTC, however cheaply, the normal settlement will apply.

  4. kbluck 05/30/2009 at 2:40 PM #

    Article VI, Section 19 (p. 84) ‘Shortage of Underlying Securities’ is probably also applicable.

  5. Mark Wolfinger 05/30/2009 at 3:25 PM #

    I agree. This stock will surely not stop trading. In fact, I anticipate very heavy volume.
    Perhaps it’s best to just wait for the OCC and the exchanges to make their announcements.

  6. Mark Wolfinger 05/30/2009 at 3:26 PM #

    I don’t think there will be a shortage of shares, but sometimes these legal documents are not translatable into English.

  7. kbluck 05/30/2009 at 3:42 PM #

    I think the important point for your readers to understand is that the OCC will guarantee all owners of option contracts shall receive a fair settlement per the terms of their contract, regardless of the stock’s ultimate fate. And conversely, that the OCC will ensure option sellers perform their obligations even if the stock vaporizes.
    Most traders pay no attention to the OCC, but none of us would be in this business without their attention to detail.

  8. Mark Wolfinger 05/30/2009 at 4:48 PM #

    Agree. The OCC works its magic behind the scenes.
    Every put holder is guaranteed that his/her right to sell shares at the strike will be honored.

  9. jackie_jj 06/07/2009 at 3:11 PM #

    Very timely topic. My Broker IntercativeBrokers.com, assured me that my June $4 Puts will exercise automatically as long as they are in-the-money (which is to be expected). This will create a short position for me. I also happened to own the same number of GM June SSFs that will deliver the shares to cover my short position.
    The advantage of having it all in IB (Interactive Brokers) account is the fact that auto exercise is free of any commissions or fees.

  10. Mark Wolfinger 06/07/2009 at 4:01 PM #

    Jackie,
    That’s one advantage to trading with IB.
    Glad to see your long stock position was nicely hedged with puts. Obviously the upside would have been better for you, but at least you reduced risk significantly.