Understanding the underlying equities is essential for success in options trading and other derivatives. The value of options, futures, and other derivatives is dependent on the value of the underlying stock or other security. Events like mergers, stock splits, and large cash distributions can significantly impact the value of derivatives by changing the underlying security. Traders need to understand how different events affect the underlying to make profitable choices about exercising options or letting them expire.
2. When trading options, trading
futures, buying convertible
bonds, engaging in equity
swaps, or trading exchange traded
derivatives, understanding
underlying equities is basic to
success.
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underlying-equities/
3. The market in the overlying
option, future, etc. is dependent
upon the market in underlying
equity.
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underlying-equities/
4. For example, when there is a stock
split, a company merges with
another company, or a company
makes an unusually large one time
cash distribution these events
fundamentally change the value of
the over lying option.
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underlying-equities/
5. Understanding underlying equities
is essential to understanding
options trading. Asking what is an
option worth is basically asking the
value and promise of the
underlying equity.
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underlying-equities/
6. The underlying security of an
option is usually common stock
but it can be American Depository
Receipts (ADR’s), preferred
stock, or other instruments.
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underlying-equities/
7. In the event of a merger or
acquisition the underlying equity
may change from common stock to
another instrument. Different
kinds of options trading will be
affected differently in the event of
a merger.
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underlying-equities/
8. For example, in a merger some
shareholders may elect to receive
cash and others may elect to
receive shares of the surviving
company.
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underlying-equities/
9. If a trader has engaged in a long
straddle options strategy in the
company that is being merged into
the other he has the option and
right to exercise the call option
that is half of his strategy.
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underlying-equities/
10. This will allow him to buy the
stock if he exercises prior to the
date at which shareholders must
choose cash or the surviving stock.
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underlying-equities/
11. Understanding the underlying
equities in this situation will allow
the trader to profit if having stock
in the merged company is
profitable. It will also allow the
trader to let the call option expire
unexercised if exercising would be
a losing proposition.
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underlying-equities/
12. Understanding underlying equities is
as important as understanding strike
prices and spot prices in options
trading. The spot price of an option is
always dependent upon the price of
the underlying equity and the strike
price is simply the spot price at the
time the option is offered.
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underlying-equities/
13. Mergers are not the only event that
can dramatically change the value
and potential of an option
contract. Although regular
dividends do greatly effect an
option large, one time, cash
distributions will.
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underlying-equities/
14. If a cash distribution is announced and
will occur in the near future the holder
of a call option will probably want to
exercise the options contact just
before the distribution unless the
stock had dropped so far below the
spot price that taking the distribution
would still result in a loss.
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underlying-equities/
15. In recent years Microsoft gave
shareholders a huge one time cash
distribution. Microsoft was not in
trouble. Its share price simply had
not been going up.
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underlying-equities/
16. Anyone who is able to cash in on
such a bonanza will find that
understanding underlying equities
is very profitable.
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underlying-equities/
17. On the other hand when a
company announces a huge cash
distribution for shareholders of
record on a previous date all that
the trader can do is wish they had
exercised the option before that
date.
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underlying-equities/
18. Risk management in options trading
may include avoiding buying options
where the underlying company is close
to bankruptcy. The promise of this
situation is that the company may
solve its problems before going
bankrupt or may become a takeover
target and see its stock soar providing
the holder of a call option a tidy profit.
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underlying-equities/
19. If, on the other hand, the company
goes bankrupt it will typically then
trade on the over the counter market.
The holder of an option can then
exercise the option and buy the stock
which will then trade on the OTC
market or simply close the position.
Understanding underlying equities
will help the trader avoid making
these sorts of choices.
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underlying-equities/
