Sears Holdings Corp’s (NASDAQ: SHLD) liquidation seems to be inevitable now, as the company looks for ways to repay the $134 million it owes to several major lenders. The lenders themselves are pushing for liquidation, while Sears offers alternative solutions to stay afloat – including the closing of hundreds of retail locations. It’s just too bad that Sears’s management was unable to find this creative spark earlier, before creditors came knocking at their door.
So, as Sears inches ever closer to declaring bankruptcy (which is expected on Monday), shares of SHLD have plummeted – dropping almost 80% since September 10th. And with liquidation on the horizon, some investors stand to make a whole boatload of cash on their bearish predictions.
The Sears bulls, not so much.
Many of the investors involved with Sears right now didn’t buy or short shares of stock, though. Instead, they bought call options (bulls), waiting for a recovery, or put options (bears), ready for SHLD to continue its descent.
That then begs the question, which is often asked by novice investors in such a situation:
What happens to options when a company goes bankrupt?
While this is an important question, it rarely comes up as full-on bankruptcies for publicly traded companies are few and far between.
To answer the inquiry, though, whenever a company files for bankruptcy, it’s officially illiquid – meaning that it can’t pay its lenders. This could be caused by flaws within a company’s business model that sometimes arise from a change in leadership, or more commonly, a slow erosion of market share.
In this case, Sears was a retail dinosaur, and refused to get with the times. Now it’s dead. Is that really a surprise?
Regardless of the reason, though, after a company does file for bankruptcy, the trading of stocks and options on the underlying asset (in the case of Sears, shares of and options on SHLD) is frozen when the company eventually gets close to actually going bankrupt – meaning that they are unable to pay their financial obligations to lenders.
From there, the company sells off all its assets, paying off what it can to creditors before closing shop for good. When that happens, its shares evaporate into thin air, becoming worthless.
“Now wait a minute,” you may be asking, “that doesn’t answer my question about options!”
Okay, okay – I’m getting there, hold on.
If a company goes bankrupt and you’re holding call options, the share prices drop, leaving your call option to expire, completely useless. Moreover, nobody would be willing to buy a call option on stock that doesn’t exist. The same thing happens to out-of-the-money (meaning the stock price is below the strike price) call options when they expire.
So holding call options on a stock that’s going bankrupt is a big no-no.
On the other hand, we have puts.
If you have put options on the stock of a company that’s filed for bankruptcy, you could have a major payday in the near future. Because the delivery and settlement of every stock option is guaranteed by the Options Clearing Corporation (OCC) in the United States, whoever sold you your put options is obligated to fulfill their promise – locking in your profits.
“But didn’t you say the trading of stock shares and options are halted during a bankruptcy?” you may be wondering, “How can anyone sell their put options when trading is frozen?”
When trading is suspended, stock and options trading is then moved to the Over The Counter (OTC) markets, also known as the “Pink Sheet” markets. From here, you can sell your put options as you please, because remember – your right to sell shares of the bankrupt company (or the option itself) is guaranteed by the OCC.
This is good news for bears who are able to snap-up puts before an impending bankruptcy becomes obvious. Investors that wait too long, though, won’t be able buy puts – as nobody in their right mind would be writing them with a liquidation rapidly approaching.
In the case of Sears, bears who own puts are about to cash in big-time once the company files for bankruptcy (which is expected on Monday), and the poor suckers who wrote those options will be forced to eat sizable losses – all because of the darn OCC.
So, as it turns out, sometimes it pays to be a curmudgeon, especially when it comes to evaluating decrepit retailers in a post-Amazon world.