We sell a covered call or cash-secured put and then the underlying company files for bankruptcy. What happens next? How are our positions effected? Let me premise my remarks by saying how unlikely this scenario is for investors who follow the rigorous screening process of the BCI methodology. But there is a difference between unlikely and impossible so let’s discuss the impact bankruptcy has on our sold call and put options for purposes of furthering the education process.
Defining an option contract
Options are legal, financial contracts between buyers and sellers. They are not issued by, nor are they the responsibility of the underlying company. Options holders (buyers) have the right to buy or sell shares of stock and sellers of options have the obligation to fulfill those contracts. The risks and rewards of these contracts are contained between the two parties involved therefore the bankruptcy of the underlying company may have significant results for those involved with options. The delivery and settlement of every stock option traded on US exchanges is guaranteed by the OCC, the Options Clearing Corporation.
What happens after a company files for bankruptcy?
Trading in its stocks and options are suspended on the major exchanges and then trading of that company’s stocks and options moves to the Over The Counter (OTC) market or what is known as Pink Sheet market.
Impact on put options
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 Options Clearing Corporation. Whoever sold you that right to sell shares of that company at that higher price is obligated to fulfill that obligation, so your profit is guaranteed.
Put sellers (that’s us folks)
If we sold a put option, we are obligated to buy the shares at the strike price despite the substantial price decline a bankruptcy filing causes.
Impact on call options
As the shares drop in price our call options simply expire worthless as the underlying hits rock bottom. The option expires way out-of-the-money
Call sellers keep the option premium as the call expires worthless and out-of-the-money
The short call expires worthless and the premium credit is realized. However, the long stock position will convert this to a damaging loss.
Put buyers and call sellers benefit from bankruptcy filings. Call buyers will lose the cash used to buy the option while put sellers and covered call writers are the big losers. One of the reasons the BCI methodology uses a three-pronged approach to stock screening is to avoid such situations. It is highly unlikely that a company performing on elite levels from all three perspectives (fundamental, technical and common sense) would then move to file for bankruptcy. Highly unlikely but remotely possible.
Global stocks trended sideways this week, slightly up in the US. The Fed appears to be benign regarding future rate hikes and oil may have bottomed. With earnings season approaching, I am feeling more bullish regarding the short-term market performance. The Chicago Board Options Exchange Volatility Index (VIX) dropped to 13.10 from 16.15 last week. This week’s reports and international news of import:
- Fed chair Janet Yellen said the Fed will proceed with caution given concerns over global financial and economic developments. Markets are currently pricing in less than one additional hike between now and the end of the year
- The US labor market added 215,000 jobs in March
- The unemployment rate rose from 4.9% in February to 5.0% in March, but the rise was attributed to an increase in the participation rate, which rose to 63% of the workforce
- Average hourly earnings rose 2.3% year over year
- Both the “official” Chinese government PMI and the Caixin manufacturing index, which focuses on smaller and medium-sized companies rose, in March. The official PMI rose to 50.2, meaning the manufacturing sector expanded in March
- The Institute for Supply Management’s manufacturing purchasing managers’ index rebounded strongly in March, rising to 51.8 from 49.5 in February
- The new orders index rose to 58.3 from the February reading of 51.5, a sign for future production. The manufacturing sector expanded in March for the first time in six months
- Japan’s industrial production fell 6.2% in February, the sharpest decline since the March 2011 earthquake. The decline suggests that gross domestic product may decline in Japan for the first quarter, which would make two consecutive quarters of declining GDP
- Credit rating agency Standard and Poor’s downgraded the outlook for China’s government debt. This is the second outlook downgrade during the month of March. Moody’s made a similar move earlier in the month. China’s credit outlook is now negative at both Moody’s and S&P
THE WEEK AHEAD
- The Reserve Bank of Australia holds a rate-setting meeting on Tuesday, 5April 5th
- Global nonmanufacturing purchasing managers’ indices are released on Tuesday, April 5th
- China releases its foreign exchange reserve data on Wednesday, April 6th
- Minutes of the March meeting of the Federal Open Market Committee meeting are released on Wednesday, April 6th
- Accounts of the European Central Bank’s March meeting are released on Thursday, April 7th
- Canada releases its March unemployment data on Friday, April 8th
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of March 2nd
BCI: Moderately bullish, favoring out-of-the-money strikes 2-to-1. Earnings guidance from the last quarter painted a bearish picture moving forward. I believe there will be many more positive surprises due to lowered expectations this quarter (one man’s opinion)
Wishing you the best in investing,
Alan ([email protected])