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Companies on the verge of bankruptcy make for interesting and dramatic investing opportunities. The potential for upside is appealing — after all, how much farther can they go down?
Just look at Ford (F), which went from needing a government bailout to a billion-dollar profit. But then there’s CIT Group, which just announced a pending bankruptcy.
It may be tempting to take a big position in a very low-priced, distressed stock in hopes of seeing spectacular gains, rather than buying something that is fundamentally sound with limited upside. But there are a lot of risks associated with these stocks.
Some investors think those risks can be avoided by purchasing options rather than the socks themselves, but that is not necessarily the case. The risks are not isolated to whether the company can emerge from bankruptcy. There is also a risk of an illiquid market, which is particularly important for options traders to understand.
I’m not saying that aggressive traders should not be buying and selling these stocks and options. But, before they do, they need to truly appreciate the risks involved.
So let’s look at what happens to a stock or option when a company goes into bankruptcy.
What Happens to Options in a 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 the case because most calls and puts are on common stock. A common stock shareholder is usually in last position during a 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 below, I will go into more detail about what happens to an option when trading is halted.
In the video, I 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.
For more from Learning Markets, see Understanding How Stocks and Bonds Work Together.
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