Long-time subscribers have seen me do the “Bankruptcy Trade” a few times in the past, mostly to success. Today, a stock that I long ago put as a short into the Revolution Investing model portfolio, A123 Systems, did exactly as I predicted years ago in columns titled such things as “How to trade the popping alternative energy bubble“, “Six stocks to get short for 2011” and “Solar firms are doomed and other news“ — it declared bankruptcy.

The stock is down 75% and is trading at 6 cents right now. I’m going to buy a tiny bit of this stock for a Bankruptcy Trade and I plan to hold it for the next week or so and then sell it and never ever look back at trading it again. It’s a trade. Period. AONE’s stock will eventually probably be completely worthless as I’ve said for years now. But for the next couple weeks, here’s the logic:

Anyway, here’s the deal with buying a stock the day it files for bankruptcy, as taught to me by my old mentor, James Altucher:

Buying Bankrupt companies

The day a company declares bankruptcy is often a great buying opportunity. Generally, all the selling is over. When the trading halt is lifted, everyone tries to cover their shorts forcing the stock up. These stocks can be rocket ships, doubling or tripling in the next several days.

And some more background on the trade’s concept:

James: Typically, when a company declares bankruptcy, the stock is halted by the exchanges so the company has time to disseminate the news of their downfall. Note that it’s NEVER a surprise when a company declares bankruptcy. It’s not like Worldcom was a $50 stock and then they whipped out a Chapter 11 filing while everyone was asleep. By that point Worldcom was the subject of dozens of lawsuits, headlines every day about corruption, all executives being fired, and the debt was trading for pennies on the dollar. The stock itself was around 10 cents on bankruptcy day.
Everyone who was going to bet on this bankruptcy was already short the stock. Not only were they short, but probably almost every executive was short the stock in order to hedge their worthless shares. And everyone who was long the stock as an investment had already most likely sold the stock by this point. Certainly all mutual funds were out of it by this time (they never hold a 10 cent stock).
So what happens, when a stock declares bankruptcy, it’s halted, and then the halt is lifted later that day. Well, nobody is selling (because they all already sold) and everyone is covering their shorts (the worst has already happened and it’s not going to get any worse). So these stocks tend to double or triple in value within 2-3 days, as happened in the case of Worldcom, Enron, FAO Schwartz, and countless other mega-cap bankruptcies.

Do not put much money in this trade. It’s very high risk and short-term oriented and the Bankruptcy Trades don’t always work out.