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What Happens to the Value of an Option When a Company Declares Bankruptcy?

With the recent bankruptcy of MF Global, those who trade options will want to know; what happens to my options? Good question. Let’s take a deeper look.

Options are contracts. Legal, financial contracts between two parties. They are not issued by, nor the responsibility of the company whose stock the options are derived from. Options can be thought of as a wager between two parties who have differing expectations about the future price behavior of the underlying stock. Since the risks and rewards of this wager are contained between the two parties involved, then the bankruptcy of the underlying company may have dramatic results for those involved with options.

The delivery and settlement of every stock option is guaranteed by the OCC, Options Clearing Corporation, in the US Market. That’s why there are margin requirements when you have risk in an options trade (such as selling verticals or selling naked options).

If you own put options on stocks of a company that has just declared or filed for bankruptcy, you are in for your maximum potential reward. 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.

If you sold pus on the underlying equity, then you are going to experience your maximum loss.

Since long calls provide the owner the right to buy the underlying equity, those options will expire worthless.

The seller of a short call, however, will keep the entire credit of the transaction and the short call option will expire worthless.
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 illiquid and insolvent and not the person or institution who sold you those put options, you are guaranteed your profit and delivery.

Jeff McAllister
OptionsANIMAL Instructor

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Jeff McAllister

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