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In order to hedge an ETF position in a portfolio, one might consider purchasing put options to protect against a decrease in price over some period of time. Some more exotically-structured funds (such as SVXY, XIV, among others, although XIV is an ETN that doesn't have options) define in their prospectuses very specific criteria by which, in a crisis situation, the fund will be unwound and capital returned to investors. The shares are no longer tradable, therefore it seems it would be impossible to fulfill the terms of the option contract.

What happens to existing options positions on a fund when the fund closes in this way? Do they expire worthless (a very undesirable result for a hedge)? Are they required to be cash-settled? I suppose this might be similar to a stock bankruptcy/delisting situation, in which the stock is no longer tradable on an exchange by the expiration date of the option.

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    Probably cash-settled at the exchange's official closing price for the ETF, which in turn should be the percentage fund investors get returned (or pretty close). You'd need to check the documentation though as it may well vary.
    – TheMathemagician
    Aug 8, 2017 at 17:14
  • @TheMathemagician: Yes, it is pretty well-defined in the prospectuses exactly how the capital return amount is calculated (at least for the two funds I gave as examples). However, since the options exchanges are entirely separate from the stock exchange that the ETF/ETN is traded on, I suspect they would have their own rules on such a thing. I just haven't had success in locating an authoritative source on how this situation would be handled.
    – Jason R
    Aug 8, 2017 at 17:31
  • This might be one of such cases (termination of XIV). It was descending quite rapidly since a few days, on February 5 it closed at ~$99 and the next day it opened at ~$4. Credit Suisse was both the issuer and the biggest holder of these notes. Their announcement linked above outlines how the existing XIV positions will be liquidated.
    – SantiBailors
    Feb 8, 2018 at 12:11

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When the fund is unwound the shares of the ETF or ETN would be replaced with a "basket" of stuff (whatever the ETF or ETN is unwound to).

This could be a collection of the securities in the ETF or ultimately cash. The options would then be on cash, so the value of the calls and the puts would be rights to buy and sell the cash (or basket of stocks at a given price).

The puts would continue to provide the hedge as you could exercise them up until the time that the options were de-listed (which may be before the expiration date).

The same kind of thing happens when corporate actions occur, such as when a company spins off a subsidiary - the options with an expiration date after the spinoff become options on a basket containing the original company and the spin-off.

The Options Clearing Corporation is the authority on this type of thing as they are the counterparty for all US exchange traded option trades.

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