What Happens To Options During Bankruptcy?

What Happens To Options During Bankruptcy?

What Happens To Options During Bankruptcy - Introduction

"What Happens To Options During Bankruptcy?" This is perhaps the second most frequent question beginner option traders ask shortly after option trading for real. This is an extremely important question to answer as listed companies do go bankrupt or file for bankruptcy from time to time and not knowing what's going on definitely throws every amateur options trader into disarray and confusion, leading to all the wrong actions.

What Happens To Options During Bankruptcy - What Is Bankruptcy?

A company files for bankruptcy when it can no longer service the financial obligations that it is supposed to, hence illiquid. Maybe the business doesn't work anymore and maybe it is making money too slowly to pay off big debts. Whatever the reason may be, when a company files for bankruptcy and actually comes very close to actually going bankrupt, trading in its stocks and stock options get suspended. The company then sells all its assets, pays off creditors and then winds up. After winding up, its shares will no longer exist.

What Happens To Call Options During Bankruptcy?

When a company declares and files for bankruptcy and you are holding call options, the shares drop and your call options simply expires worthless when the underlying stock hits rock bottom. In fact, it is the same as having the stock drop enough to put those call options out of the money upon expiration.

What Happens To Put Options During Bankruptcy?

If you own put options on stocks of a company that has just declared or filed for bankruptcy, you are in for a huge reward. The delivery and settlement of every stock option is guaranteed by the OCC, Options Clearing Corporation, in the US Market. Whoever sold you that right to sell shares of that company at that higher price is obliged to fulfill that obligation, so your profit is guaranteed. The only question is, what happens when that company files for bankruptcy and trading in its stocks and options are suspended? When that happens, trading of that company's stocks and options moves to the Over The Counter (OTC) market or what is known as "Pink Sheet" market where you are able to either sell those put options for a profit or exercise the options and sell the stocks for the same profit. Since it is the company that is going illquid and insolvent and not the person or institution who sold you those put options, you are guaranteed your profit and delivery.

The most recent example of this are put options on the collasped Lehman Brothers (ex-Ticker : LEH) which filed for bankruptcy on 14 Sep 2008. After filing for bankruptcy, Lehman Brothers' shares moved from the exchange to the OTC market (Ticker Symbol LEHMQ or LEHMQ.PK) where it traded at $0.05 per share on 18 Sep 2008. That is when put option holders can choose to exercise the put options by buying the shares at $0.05 and selling it at the strike price for a big profit.

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