What happens to the value of Put Options if the underlying stock goes bankrupt?

April 27, 2006 7:52 AM

Speculating Filter: What happens to the value of a Put Option if the underlying stock halts trading and/or goes bankrupt?

I'm a believer in a housing bubble and a bear on the residential real estate market.

I recently made my first foray into speculating by going long LEAP Puts (Long Term Equity AnticiPation Securities) on several homebuilders.

Doing some quick calcs on one of them (homes started, homes in inventory, rate of sale, % decline in median price, holding costs, cash on hand) I think there is a chance one of them might go bankrupt before the LEAPS expire if the housing market continues to decline.

What happens to the value of a Put Option if the underlying stock goes bankrupt and/or halts trading? Does the option become worthless because it can't actually be exercised?

posted by de void to Work & Money (9 answers total)

What happens is: you win! Your option is traded on the CBOE and the settlements are handled by the clearinghouse. The actually deliver of stock is not your problem - you just sell your option at the prevailing price on the options exchange.
posted by mullacc at 8:10 AM on April 27, 2006

There are some rules about trading options if trading in the underlying stock halts. But I don't think it's possible that there would be an outcome whereby the stock goes to zero or close to zero and you don't get to benefit from your short position.
posted by mullacc at 8:21 AM on April 27, 2006

I don't know how much money you have or how sophisticated you are - but there is also a very nascent MBS credit default swap market out there. Maybe a purer way to speculate on home price declines - especially if you can find one linked to an ABS with a lot of sub-prime I/O mortgages.

I don't know much about it, but it strikes me as an interesing concept. It may not even be developed enough to acutally buy the derivatives today.
posted by JPD at 9:51 AM on April 27, 2006

Best answer: Just to confirm my answer above, here's the FAQ from the Options Industry Council.
posted by mullacc at 11:57 AM on April 27, 2006

Response by poster: For the archive, here's the specific section from the FAQ mullacc linked:

"Q: A company I own options in recently declared Chapter 11 bankruptcy protection. What does that mean for my options?

A: Following a bankruptcy announcement, trading in the underlying stock might be suspended by the primary exchange that lists the security. If trading in the underlying stock has been halted, trading on the options will be halted as well. However, if the underlying stock begins trading on the OTC Bulletin Board or on the "Pink Sheets," investors will be able to close out any existing positions, i.e., 'closing only' transactions. No new or 'opening' trades are permitted. Investors may also exit their position through exercise instructions to their broker resulting in the physical delivery of the bankrupt company's shares."

JPD, thanks, but I doubt I have the capital necessary to play in credit swaps. It does bring up the question though, how can someone verify exactly what is the credit quality of the mortgagors/value of the properties backing an individual MBS.
posted by de void at 12:48 PM on April 27, 2006

Very little would likley happen: (1) stocks rarely stop trading with a bankruptcy filing, (2) bankruptcy filings are rarely a surprise, (3) options can (and, in many cases, should) be sold before their expiration date.
posted by GarageWine at 12:57 PM on April 27, 2006

how can someone verify exactly what is the credit quality of the mortgagors/value of the properties backing an individual MBS.

The prospectus (and subsequent filings) will have summary information which is pulled from the "tapes", i.e. a file that includes a line of information for each loan (FICO scores, LTV, location, etc.). I'm not sure how big of player you'd have to be to actually get a hold of the tapes - I've only seen them in M&A situations.
posted by mullacc at 12:59 PM on April 27, 2006

Even if your options expire, you're going to go short the shares at your strike price, and if they don't exist anymore, that is the best possible scenario for a purchaser of puts (or someone who's shorted calls). You exercise, get the proceeds from the sale of stock, and then you don't have to deliver anything.

I just kind of wanted to clarify, because it was sounding like you would possibly miss out or something if you did let the options expire - you'll always be able to exercise your options if you're long, and if their value is nil, then perfect.

If you're short a worthless or near-worthless stock, the clearing firm might force a buy-in, at a nominal price like a penny per share, where they deliver the shares at the stated price for you, effectively closing out the short position and realizing your gains. Either that, or your broker should be able to talk to them if it's truly worthless and wipe out the position, since you've already received the proceeds from the sale.
posted by mckenney at 2:20 PM on April 27, 2006

The credit quality of an RMBS is generally judged by the rating agencies (S&P/Moody's). They will assign an initial rating on the issue date of the RMBS asset and then will continuously monitor the quality of the underlying pool of mortgages for the duration of the life of the deal. They will then up/downgrade their rating as necessary. These ratings are public on the agencies websites. The mix of mortgages in the pool will be disclosed in the prospectus on the issue date.

I'm not aware that these sorts of ABS assets are available to retail (as opposed to HNW or inistitutional) customers because the analysis required to see if they're a good deal is pretty hardcore.
posted by patricio at 2:36 PM on April 27, 2006