How To Profit From a Bankruptcy

RetailBuilder · Dec 31, 2007

It looks to me as a noob (not even that, really, more like a fetus) that shorting some of these homebuilders and monoline insurers has reached a point of diminishing returns, beyond which only outright bankruptcy will drive them materially lower.

It seems to this schlump that this would become a zero-sum game, i.e., if you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades.

I have obviously never been in this situation.

So my question is: If you are short a company that suddenly declares BK, does there still exist an exit to that trade?

Or, more succinctly, if I believe a company is going BK, how best to profit from that?

ssblack · Dec 31, 2007

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if you short stocks of a company, you aren't buying them from that company???

psytrade · Dec 31, 2007

I guess if you put on a bunch of credit default swap trades and the counterparty - a bond insurer or something went bankrupt, you would have a hard time collecting on your profits.

Never thought that could occur. Interesting idea.

NYOBScalper · Dec 31, 2007

Quote from RetailBuilder:

So my question is: If you are short a company that suddenly declares BK, does there still exist an exit to that trade?

You don't need an exit. If the company you sold shares of is bankrupt, you don't have to buy the shares back to return to the borrower: thus you get the full profit. When you short-sell, the cash from the sale goes into your account, and you should even earn interest on it. You've sold the stock. If the company goes bankrupt, you sold stock and kept money in your account and the stock is now worthless so you're straight and the people who were long... are out everything.

RetailBuilder · Dec 31, 2007

Quote from NYOBScalper:

You don't need an exit. If the company you sold shares of is bankrupt, you don't have to buy the shares back to return to the borrower: thus you get the full profit. When you short-sell, the cash from the sale goes into your account, and you should even earn interest on it. You've sold the stock. If the company goes bankrupt, you sold stock and kept money in your account and the stock is now worthless so you're straight and the people who were long... are out everything.

Thank you for that. I have never shorted the underlying and didn't know if an unwind of some sort was required.

However, if I was short the options and the underlying suddenly went to zero, would an exit exist?

ProfitTakgFool · Dec 31, 2007

Yes, the stock would go to a penny, or thereabout, on extremely strong volume. You would be buying to cover your short and there will be plenty of sellers.

Quote from RetailBuilder:

Thank you for that. I have never shorted the underlying and didn't know if an unwind of some sort was required.

However, if I was short the options and the underlying suddenly went to zero, would an exit exist?

RetailBuilder · Dec 31, 2007

Quote from ProfitTakgFool:

Yes, the stock would go to a penny, or thereabout, on extremely strong volume. You would be buying to cover your short and there will be plenty of sellers.

Ok, thank you.

Buying puts to open, which would require selling to close, would not be a wise trade in this situation then.

bandit77 · Dec 31, 2007

Quote from RetailBuilder:

Ok, thank you.

Buying puts to open, which would require selling to close, would not be a wise trade in this situation then.

you get the full value of the put. if you bought a put when the stock is at 20, it goes to 0, your put is worth 20. profit would be 20 minus whatever premium you paid for it.

puts are also exchange settled so you don't have to worry about counterparty risk. the other party's broker, and ultimately the exchange, bear the risk of the other party's insolvency. that's why you can't margin options, no one wants the risk.

RetailBuilder · Jan 1, 2008

Quote from bandit77:

you get the full value of the put. if you bought a put when the stock is at 20, it goes to 0, your put is worth 20. profit would be 20 minus whatever premium you paid for it.

puts are also exchange settled so you don't have to worry about counterparty risk. the other party's broker, and ultimately the exchange, bear the risk of the other party's insolvency. that's why you can't margin options, no one wants the risk.

Thanks alot Bandit, I didn't know that either, but it makes sense.

I really appreciate it.