Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
OPTIONS AFTER BANKRUPTCY
How does the bankruptcy of a company affect its options contract? Do all the options expire worthless?
When a company files for bankruptcy protection, some options may expire worthless, but not always. After the company files, the first step is delisting; stock is often delisted from the exchanges within days, if not the same day of the announcement. In rare instances, it takes longer. For example, Delta Airlines (DAL) filed for bankruptcy in mid-September, but shares continued trading on the New York Stock Exchange (NYSE) for several weeks. The NYSE recently announced it would delist the stock on October 13, 2005.
Once the shares are removed from the exchanges, the stock begin trading on the OTC Bulletin Board, or “pink sheets.” The stock symbol changes, but shares continue trading and can be bought and sold. At that time, however, the options are affected. To be specific, once the stock is delisted, options can be closed out, but no new positions can be opened. However, it is possible to institute closing transactions. If, for example, an investor owns puts, that position can be closed out even after the stock is delisted.
From that point forward, the bankruptcy court comes into play. The courts review the company's status, and if they decide the stock is null and void, the call options will expire worthless and the puts can be exercised for cash. These are general guidelines, but not set in stone. Each company and situation should be reviewed separately, and the specific adjustments to the options contracts can be found in the informational memos section of the Options Clearing Corporation (OCC) website, www.optionsclearing.com.
ADJUSTING WINNING TRADES
I've read a lot about adjusting losing trades, but what about a winning
situation? Specifically, if I have a bull call spread that's deep in-the-money
with several months remaining before expiration, but also expect the stock
to
continue higher, would it make sense to add another call above
the short strike?
This is a good problem to have. You have a winning trade and you want to lock in those profits or position yourself for another move higher. There is only one surefire way to protect your profits: Exit the trade and book the profit.
However, you can adjust the position if you expect the stock to move higher. Let's first review the trade. A bull call spread is created by purchasing a call and selling another call with a higher strike price. Using hypothetical numbers, if ZYX is trading for $39 a share and I expect a move to $45 by year's end, I can create a bull call spread by purchasing a January 40 call for $3.00 and selling a January 45 call for $1.00. The cost of the trade is equal to cost of the long call minus the short call, or $2.00. The maximum profit is equal to the difference between the two strike prices minus the cost of the trade, or 5 - $2.00 = $3.00 per spread. For each contract, I am risking $200 to make $300.
If, as expected, the stock moves higher, the trade will begin making money. Suppose the stock rallies on strong earnings and is near $46 with three months left until expiration. The January 40 call is worth $7.00 and the January 45 is quoted at $2.50. My spread has widened to $4.50, which is a good thing.
However, now I expect to the stock to rally up to $51 a share by expiration, and I can participate in the move by adjusting the position. First, I continue to hold the January 40 call. No changes made there. Then I close out the January 45 call for $2.50, which results in a $1.50 loss because I sold it for $1.00 and am buying it back for $2.50. At the same time, I will sell a January 50 call for $1.50. The premium received for selling the higher strike call will cover the loss from the sale of the January 45 call. Then, my maximum profit potential also grows. It's still equal to the difference between the two strike prices minus the cost of the trade. The difference between the two strike prices is now 10. So, the maximum profit is 10 - $2.00 or $8.00. In short, one way to adjust the successful bull call spread is to roll the short strike up. Obviously, this can only be done with a lot of time to expiration.
SIZING UP SYNTHETICS
What does the term “synthetic” mean in options? For example, what does it mean when traders talk about synthetic long puts or synthetic straddles?
A synthetic position is one that replicates another position, but uses a different combination of shares or contracts. In your example, a synthetic equivalent to long put is short stock and a long call. The two positions behave the same and will have identical risk graphs, but one is created with puts and the other with stock and calls. Synthetics are an important element of option pricing and can be used to identify arbitrage opportunities. This is generally domain to large institutional investors and market makers, rather than retail investors or traders.
Originally published in the December 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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