What happens to put options when a company goes bankrupt?

DawnPennington answered one year ago …

If a company goes bankrupt, the puts skyrocket in value. That's the "short" answer.

The real answer is that everything lies in the hands of the market-makers who are stationed all over the country and are responsible for monitoring trading in and setting prices for the stocks that are assigned to them.

If you’ve ever seen an option close the day at $2 and suddenly it’s showing $2.50 by the next opening bell, it means that a whole lot of stock must have moved overnight and pushed the price up; ergo, the option is suddenly worth more in the morning. (Or less, given this kind of market.)

It's a tricky situation right now because stocks are moving all over the place and volatility has gone parabolic, which, of course, pushes up option premiums. But with volatility pulling back right now, we’re seeing a significant decrease in premiums that isn’t necessarily matching what the underlying stock is doing. I

It’s a very strange trading environment indeed and it means that, again, the poor market-maker is struggling just to keep up!

Most traders, though, just want to know how they get their money if they're holding puts for a company that's going bankrupt. Essentially, that market-maker is playing matchmaker between buyers and sellers.

You cannot get into a trade UNLESS someone is willing to take the opposite side of it. You may want to offload your shares of a stock that’s heading toward bankruptcy, but you can’t unless someone is willing to pay you for it. Which, well, you take what you can get or you may not get anything at all when it’s stock.

But when you own puts, you’ve got an agreed-upon strike price and if you want to exercise that put at $60, then you can put your shares to the guy who shorted the puts or you can at least demand the option value if you don’t have the stock to put to someone.

But the good news is that you’re not dealing with the company – you’re ultimately dealing with the Options Clearing Corp. now, which ensures that trades are honored and cleared.

Think of it this way: On Sept. 10, 2001, there were large blocks of puts that traded on American and United airlines. When the markets re-opened a few days later, someone was rolling in cash even though the airlines’ stock prices were in the toilet. (It was all transferred to an offshore account and no one found out who did it.) So how did they get paid?

The entities that shorted the puts (which, remember, shorting puts is a bullish bet, similar to buying calls but you get your money upfront, and you keep it when the stock goes up) were assigned to pay up to settle the long put buyers’ bets.

So, really, the money comes out of the traders’ pockets. That’s why we recommend “shorting” by buying puts. The most we pay is the most we can lose.