A very risky, three day trade…of a penny stock

A very risky, three day trade…of a penny stock

Want to know an exception for a professional money manger to the “Don’t ever trade a penny stock” rule that I truly believe the mass of investors should listen to?  When a huge company’s stock is halted for bankruptcy and then reopens.

AMR is halted, reported to be in bankruptcy.

I’m taking a tiny bit of capital and bidding for the AMR as it reopens.  I’ll sell it all, win or lose, by yThursday this week.  This is a rare, rare day trade that you’ll see from me and also a rare, rare penny stock trade from me.  Here’s the full explaination of why I’m doing this trade, reprinted from an article my friend James Altucher wrote a couple years ago RealMoney.com after having spent the weeks before re-explaining the trade concept to me offline:

James Altucher
Banking on a Bankruptcy
By James Altucher
RealMoney.com Contributor

2/11/2005 10:09 AM EST
URL: http://www.thestreet.com/p/rmoney/jamesaltucher/10208455.html

 Trading Strategies
  • It’s surprising, but buying the stock of companies the day after they file Chapter 11 bankruptcy can pay off.
  • This could be caused by an overload of shorts building up in the shares.
  • A look at some of the large bankruptcies of 2004 proves this.

In my book, Trade Like a Hedge Fund, and on StreetInsight on April 1, 2003, I wrote about a “system” that buys companies the day they file Chapter 11 bankruptcy. It’s time to update what has happened in the two years since I initially wrote about the strategy.

Typically, when a company files Chapter 11, the stock is halted until the exchange determines that the news has been properly disseminated so that all shareholders can digest, and act accordingly, on the new information. This is the trading equivalent of locking a movie theater’s doors so that everyone has the opportunity to hear the usher yelling “Fire!” What usually happens when the stock resumes trading is that it opens up significantly lower, and then quickly moves up 50%, 100% or even more within days of resuming trade.

Why should this happen? When a company declares bankruptcy, it basically is telling the world through formal legal means that the assets and equity built up in the company are no longer sufficient to pay its debts. In other words, the stock most likely is worth zero the moment it files for bankruptcy.

What Drives the Strategy

Large hedge funds that play bankruptcies typically do so by buying the debt for pennies on the dollar and then converting that into equity (or getting repaid on the debt) when the company emerges from bankruptcy. For instance, this is what Eddie Lampert did with Kmart(KMRT:Nasdaq) . He bought up its debt when it was in bankruptcy, and has made many billions on his investment after that debt became equity in the new, bankruptcy-free company. But it seems that nobody goes about buying the stock of a bankrupt company.

In my initial article on this topic, I used as examples:WorldCom

      , which went from 8 cents a share to 17 cents a share on more than a billion shares traded when the halt was lifted after its Chapter 11 filing.


      , which went from 26 cents to $1.26 within a day of resuming trade.


And so on. Why does this happen? Nobody really knows, but my guess is that it’s never a surprise when a company files for bankruptcy. Everybody knew that WorldCom or Enron, or even FAO Schwarz (which went from 25 cents to 63 cents the day it resumed trading after filing on Jan. 13, 2002), were in trouble and eventually were going to have to file. So what does everybody do? They start shorting the stock, rightly figuring that it’s worth zero. And when the company files for bankruptcy and resumes trading, there’s no more bad news to come out — so billions of shares’ worth of short-selling have to be covered, driving the stock up.

‘System’ Worked in 2004

I put the word “system” in quotes because it’s difficult to really get enough data to say that this is a viable trading strategy. However, I recently took a look back at some of the large bankruptcies of 2004 to see if the idea still held up.

US Air (UAIRQ:OTC BB) filed for bankruptcy on Sept. 12, 2004. On Sept. 10, its stock closed at $1.46. On Sept. 13, it opened at 71 cents as holders fled the shares before the open. By Sept. 14, the stock was at $1.23 and reached a near-term high on Oct. 4, 2004, at $1.46, more than 100% higher than the open just three weeks earlier. It was an $8.3 billion bankruptcy.

RCN (RCNCQ:OTC BB) filed for bankruptcy on May 27, 2004. The stock opened at $0.105, and the next day reached a high of $0.184.

Atlas Air (AAWHQ:OTC BB) filed for bankruptcy on Jan. 30, 2004. On Feb. 2, shares resumed trade at 25 cents. The next day, the stock price was at 54 cents.

Interstate Bakeries (IBCIQ:OTC BB) filed for bankruptcy on Sept. 22, 2004, after the low-carb diet craze caught up with it. The stock opened that day at $2.04 after trading as low as $1.30 in the preopen. The next day, the stock was at $4.25 and now is around $6.

Trump Hotels & Casino Resorts (DJTCQ:OTC BB) filed for bankruptcy protection over the weekend of Nov. 20, 2004. On Nov. 22, 2004, it reopened at 55 cents on volume of 1.1 million shares. Although the stock went as low as 48 cents that day, it never looked back. Shares reached a high of $2.12 by Dec. 7, 2004, with an average share volume in the millions in the weeks between the filing and the near-term high.

Again, in almost every case, the stock of the company has become worthless. However, the various mechanisms that make up a largely rational market occasionally can hit an overload and cause certain pockets of the market to behave irrationally. Such is the case with the short-term aftereffect of a bankruptcy filing.

James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of Trade Like a Hedge Fund and the upcoming Trade Like Warren Bufffett . At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.