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 |
PUTS AFTER BANKRUPTCY
I own January 2009 puts in a company I feel will be bankrupt in the near future. I have received conflicting responses from traders to this question: What happens to the puts of an underlying company that announces bankruptcy? Is the put writer still obligated to buy shares of the worthless stock at the strike price? Some have said trading in the underlying halts and all the options become worthless. Is that true?
There are no set rules about options and bankruptcy, but often, the puts will still have value and the out-of-the-money calls will expire worthless. To understand why, lets consider what happens in a bankruptcy. If the options are trading, then shares are probably still listed on one of the stock exchanges. However, when a company files for bankruptcy, the exchange might suspend trading and maybe de-list the stock. When US Airways filed for bankruptcy several years ago, the New York Stock Exchange (NYSE) released a memo stating that the NYSE would suspend trading in the stock because the company said it had filed to reorganize.
A de-listed stock can continue trading on the OTC Bulletin Board (the "Pink Sheets") under a new stock symbol. Shares can be bought or sold through a broker as if it traded on one of the major exchanges.
What about the options? As a rule, the options will trade, but with restrictions. It is not uncommon to see trading limited to closing transactions. If a put owner wants to close out those puts, they can, but no new or "opening" transactions will be allowed. Once de-listed, options on a bankrupt company are limited to closing transactions. Exercise and assignment will involve shares of the bankrupt company, but it might not make sense for a call holder to exercise those calls if the stock has already taken a beating. If shares are trading on the Otc, the put owner has the right to exercise that option contract. The put writer must honor it.
Eventually, the stock certificates might be declared null and void and the stock price drop toward zero. If so, the call options expire worthless and the put options settle for cash. The put owner can exercise the options and receive cash equal to the difference between the option's strike price and the stock price.
Of course, situations can vary. The best source of information regarding a specific holding is your broker. The next reliable source is the Options Clearing Corp. (OCC). Its website will contain information regarding contract adjustments from bankruptcies and other unusual situations. The web address is www.optionsclearing.com.
ASSIGNMENT RISK
How often do American-style deep-in-the-money (DITM) options get exercised? For many underlying stocks and futures, even DITM puts and calls have a healthy amount of buyers, judging from the bid sizes. This should provide DITM longs space to get out by hitting the bid. What could be the reason for early exercise?
American-style options can be exercised at any time prior to expiration, but exercise almost never makes sense when the option has time value remaining because that value is lost when the option is exercised. To compute the value of an in-the-money (ITM) option, strategists can use the following formula:
Call option price + Strike price - Stock price = Time valueTime value for an ITM put option is computed as:
Put option price + Stock price - Strike price = Time value
For instance, if I have the XYZ 50 March call options, which are currently bid for $1.50, and XYZ is trading for $51, the option has $1.00 of intrinsic value and 50 cents of time value. If I exercise the call option and buy 100 shares at $50 a share, I can sell it for $51 (the market price) and realize a $1.00 profit a share, or $100. The profit from the exercise and sale of the shares reflects the intrinsic value of the option. If I exercise, I no longer own the call. But if I sell it, I receive $150 (the premium x 100). The sale of the call results in $50 more than the exercise and share sale, due to the time value of the option.
Exercising the option when it still holds time value will result in leaving money on the table, which is true of DITM and out-of-the-money options. Sometimes, DITM options will have little or no time value as expiration approaches. By then, it might make sense to exercise the option if the strategist wants to own the shares or collect the dividend (in the case of a call) or sell the shares (if holding a put).
JANUARY EFFECT
I read that stocks see strength in January because of the "January effect." What is that and how can I profit?
The January effect is due to tax-loss selling at the end of the year. The IRS's "wash sale rule" says a stock sold at year-end to book a loss for tax purposes cannot be repurchased until 30 days have passed. Thus, many stocks beaten down one year are sold in December to record tax losses, but repurchased in January. The selling in December and buying in the first month of the year causes the January effect. It affects small stocks more than large ones. One strategy is to search for the market's biggest losers for the year. If the fundamentals look good, play them for a possible reversal in January or early in the following year.
Originally published in the February 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
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