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Paulo Santos, Think Finance (376 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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Were you surprised by AMR Corporation’s (AMR) stock going UP after the company announced bankruptcy and the stock took an initial plunge of $0.20-$0.30, as seen in the chart below?

Don’t be. It’s actually a pretty common effect; it has happened in dozens of different well-known bankruptcies, like K-Mart, Enron, Worldcom and US Air. It goes like this, on the day bankruptcy (usually chapter 11) is announced, these stocks open with a deep plunge, perhaps starting on the pre-market if trading is allowed. This part of the plunge, however, is usually the deepest – then the stocks simply turn and go into a steep ascent for days or even weeks, a rise that can easily be 100-200-500% from the lowest prices attained right after trading restarts following the bankruptcy announcement.

It isn’t easy to explain this pattern, even though it’s very, very common to see it happen. It’s like an extreme version of “sell the rumor, buy the news”, as if nothing worse can really happen because the company has already gone bankrupt. A possible explanation might lie with the closure of short positions, namely short positions assumed to hedge debt instruments, because of the way keeping these positions would eat up margin.

There are, however, 3 distinct conclusions you can take from this behavior, that will help you in trading bankrupt shares.

If you are caught in a stock that just declared bankruptcy

Don’t sell into the initial panic (unless you can sell within seconds of the announcement). Wait for a few days, and then get rid of the stock you hold. In almost every bankruptcy the shares will end up being worth zero and be canceled. Only in very rare, extreme, situations, will there be any kind of recovery for equity holders – unless you can produce the research to back up the likelihood of at least getting some warrants or a small piece of equity, you’re better served by selling while someone pays something for the shares.

If you are a crazed speculator

You now know there’s a pattern in high volume, well known, bankruptcies. You can game this, by buying around 30 minutes after the stock starts trading again following the bankruptcy announcement. Chances are, you’ll have an opportunity to sell much higher later on. Don’t get married to the shares, though… you’ll have to sell them in the next few days, as they’ll turn into pumpkins sometime after.

If you plan on buying shares of a bankrupt company

Don’t. You either speculate on them right off the bat or you won’t have any edge and will be liable to get emotionally stuck in a stock that will head to zero.

Again, almost all of these stocks end up being worth a precise zero. You cannot get married to them. If you don’t trade them in the first 30 minutes or so, you shouldn’t touch them anymore.

If you plan on shorting shares of a bankrupt company

Don’t short them in the first few days, or you might end up on the wrong side of the pattern described here. And if you short them later, don’t short them in size – contrary to anything you’d expect, these shares can go up a lot, so if you short in size you might end up being squeezed on a bankrupt company.

Source: Surprised By AMR Going Up?