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When Companies Go Bankrupt: Know Your Options


When companies file Chapter 11, here's what you can do.

With General Motors (GRM) Chapter 11 filing, this is a suitable time to discuss what happens to the options when an 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 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 - and so are all call options. The stock is usually de-listed from the stock exchanges, but continues to trade in the over-the-counter (OTC) market. If you wonder why it trades, or why anyone would pay anything for the shares, those are good questions.

Anyone who's short stock has won his/her wager. But the short position remains in the investor's account. The easiest way to eliminate that position is to buy the shares. Thus --assuming the broker cooperates and charges a minuscule fee -- it's worth it for investors to pay a small fraction of one penny per share just for the convenience of exiting the position. If you're 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 July 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's no incentive for anyone to pay that price; there's 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. As a put owner, you don't have to accept that bid; you can offer at any price you choose. But you should be reasonable, and you shouldn't ask for more than the strike price.
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No positions in stocks mentioned.

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