Far be it from me to throw cold water on all the enthusiasm amongst investors to buy shares in Ford (F) General Motors (GM) or other insolvent companies, but I do think it is wise to understand what the real risks are before making a risky investment. Buying these stocks or options on these stocks is not inherently a bad idea but this article will help you set expectations and prepare.

Currently (late 2008) the US congress is nearing a reported deal to bailout the big three automakers (although Chrysler LLC, is not even public and is even less transparent than its counterparts), which has continued to reinforce interest in these defunct stocks as big potential winners.

As speculation grows about the probability of a bailout Ford (F) has returned 200% since late November. Similar returns have been seen in General Motors (GM). Return chasers are flocking to the stock, which has been trading at all time record volume levels. However, if there is one thing we know about markets it is that the crowd is most definitely not “wise,” which should be one more warning sign.

However, for those determined to take a gamble on this unholy union between Washington bureaucrats, politicians and millionaire CEOs there are a few risks to keep in mind.

1. Most last ditch efforts before bankruptcy fail. The vast majority of companies with problems so severe that they have become insolvent cannot be saved intact. So make sure you are ready to get out while the getting is still good.

2. In a liquidation common shareholders are last in line to collect assets, which effectively means they get nothing. Option holders are not even behind common shareholders; they will definitely get nothing if trading stops in the shares.

3. Long term option buyers may not fully realize that the options in these kinds of companies are inherently overpriced and even if things start to look better for the firm, they may actually continue to lose money. So be careful if you plan to speculate by buying calls. If you need more information on LEAPs options click here.

If you recognize these risks but still have too much money to store idle in your brokerage account then, by all means, buy some stock. Just remember that stocks collapse just as the last buyer executes their trade. Will it be you?

Investing in a Bankrupt Stock or Stock Option – Part Two

Note: The second part of this article was written on November 2, 2009, once a resolution had been reached on the automakers mentioned in the first half of the article but before many other distressed firms were able to recover.

Ford has gone from needing a government bailout to a billion dollar profit while at the same time CIT announced a pending bankruptcy. Distressed companies present interesting and dramatic opportunities as well as risks. Some of these are particularly important for options traders.

There is a lot of talk right now about taking some long bets on some of these near-bankrupt stocks. The potential for upside is appealing. After all, how much farther can they go down? But what happens to a stock or option when a company goes into bankruptcy?

If the company goes into liquidation (one of the potential results of the bankruptcy process) all its assets will be gone before common shareholders or option holders get any money. However, if the company reorganizes within bankruptcy shareholders may still be able to walk away with some value at the end of the process while option traders are still likely to get nothing.

This is so because most calls and puts are options on common stock, and a common stock shareholder is usually in last position during a liquidation. If a company’s assets are going to be liquidated, the secured lenders will be paid first, anything left over (usually nothing) will go to preferred shareholders and finally common shareholders get the remnants. It is extremely unusual for the common shareholders to get anything.

To make matters worse for option traders, when a company seeks bankruptcy protection, trading in its stock is typically halted. The liquid market for its shares dries up and option buyers may be left holding a worthless asset. If there is no market for the stock and expiration day passes, the option will expire worthless. Option writers, on the other hand, could walk away with the entire premium. In the video I will go into more detail of what happens to an option when trading is halted.

The real take-away from this article is not that aggressive traders shouldn’t be buying and selling these stocks and options on those stocks, but that they need to appreciate the risks associated with a company on the verge of bankruptcy. These risks are not isolated to just whether the company can emerge from bankruptcy. The risk of an illiquid market forcing all its options to expire worthless must also be accounted for.

In the article I refer to a document called Characteristics and Risks of Standardized Options published by the Options Clearing Corporation. You can get a copy of that document at the website for the Options Industry Council at www.888options.com.