man its lonely in the coffee shop...
a great read from nationalpost.com
What to do when the trading stops
Time works against holders of options on halted stock
Richard Croft
National Post
What do you do when you hold options on a stock that has ceased trading?
It is awful for an investor to be on the wrong side of the trade and not be able to do anything about it. This
happens more than one might imagine in the commodities market, when there is a run -- either up or down -- on a
particular commodity.
Futures exchanges limit the daily price movement on any commodity or financial futures contract. When, say, an
unexpected frost causes the price of soybeans or frozen concentrate orange juice to surge, traders cannot enter or
exit a position if the daily limit is breached. In some cases, the cash price of the underlying commodity may rise two
or three times the amount of the daily price limit allowed on the exchange, in which case the limits are imposed and
no trading can take place in the underlying commodity.
If you are short a futures contract on an underlying commodity whose price is rising, you have no way of exiting
your position or limiting your losses until the underlying cash market trades within the limits set by the exchanges.
What this means for the futures traders is that there are times when you can lose many times your original
investment.
This is where the limited risk characteristics of an option contract can provide come comfort, but only if you are
buying the option contract.
If you are selling options, you have the same unlimited exposure as you have with the futures contract. But if you
buy an option on a futures contract -- either a call or a put option -- the most you can lose is the cost of the
option.
Mind you, the idea of losing 100% of your initial investment may not provide much comfort for most investors.
Usually we think about such circumstances in the context of the futures markets. However, equity option traders
can face similar problems if trading in the underlying stock is halted or the stock is de-listed.
Cinar Corp. (CIFa/TSE) is an interesting case study. A trading halt was imposed in March this year, by both the
Toronto Stock Exchange and Nasdaq. Subsequently, Nasdaq de-listed the stock.
For investors who hold the stock it is a waiting game until the company provides the financial disclosures as required
by the exchanges. This is not a pleasant situation by any means, but assuming the company eventually gets its act
together and provides the necessary information, the trading halt will be lifted and the stock will have some value
pegged on it at some point.
But what about the option trader? If you own options on Cinar, time is working against you. The question is, do you
take a deep breath and absorb the 100% loss of your initial investment, by letting the options expire?
As one reader who holds Cinar call options writes: "Shortly after taking the position [in March], the stock was halted
on both the TSE and Nasdaq. I didn't worry because I had until October." But in the reader's mind, it is now
mid-August and time -- the enemy of option buyers -- is becoming an issue.
What this does is raise some interesting questions. Should the call buyer accept the fact that the option may
eventually expire worthless?
Or should the option be exercised, taking a chance that the stock -- if it does open for trading -- will have a market
price above the strike price of the option?
More to the point, since this reader bought the Cinar options on the Chicago Board Options Exchange, can the
option actually be exercised, since the underlying stock has been de-listed on the Nasdaq?
To address the latter point first, you would need to consult the Chicago Board Options Exchange as to whether the
option can actually be exercised.
My sense is that it can, because the option is an agreement between the option buyer and the U.S.-based Options
Clearing Corporation, just as the writer of the option has an obligation to deliver the securities should the option be
exercised. That the security is not listed for trading simply means that neither buyer nor seller has any guidelines as
to what is a fair price for the underlying security.
Assuming the option can be exercised, the next step is to evaluate whether it is worth going through the process.
It all comes down to the strike price of the option, and the outlook for the stock should it begin trading again.
To exercise the Cinar October 12.50 call, the investor would have to be convinced that if and when the stock begins
to trade, the market will value it at a price greater than US$12.50 (or $18.50). If the call buyer is convinced about
the potential for the stock, then exercising it may be a viable solution. But exercising an option without some
guidelines as to the value of the underlying stock is risky.
As well, investors need to understand that there can be disadvantages to an early exercise. For one thing, the
investor forgoes any time value that was paid when the option was purchased. If the investor purchased the Cinar
October 12.50 calls at US$2, when the stock was trading at, say, US$11.50, then the entire cost of the option was
time value. If the investor exercises the option, the time value disappears.
Therefore, if investors are convinced that exercising the option is a viable alternative, they should wait until the last
possible moment (in this case, the calls expire on the Saturday following the third Friday in October). Doing so
allows for the possibility to recover some time value, if the stock begins to trade before the October expiration. |
