Understanding Underlying Equities


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Understanding Underlying Equities

  1. 1. Understanding UnderlyingEquitiesBy: www.options-trading-education.com
  2. 2. When trading options, tradingfutures, buying convertiblebonds, engaging in equityswaps, or trading exchange tradedderivatives, understandingunderlying equities is basic tosuccess.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  3. 3. The market in the overlyingoption, future, etc. is dependentupon the market in underlyingequity.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  4. 4. For example, when there is a stocksplit, a company merges withanother company, or a companymakes an unusually large one timecash distribution these eventsfundamentally change the value ofthe over lying option.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  5. 5. Understanding underlying equitiesis essential to understandingoptions trading. Asking what is anoption worth is basically asking thevalue and promise of theunderlying equity.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  6. 6. The underlying security of anoption is usually common stockbut it can be American DepositoryReceipts (ADR’s), preferredstock, or other instruments.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  7. 7. In the event of a merger oracquisition the underlying equitymay change from common stock toanother instrument. Differentkinds of options trading will beaffected differently in the event ofa merger.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  8. 8. For example, in a merger someshareholders may elect to receivecash and others may elect toreceive shares of the survivingcompany.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  9. 9. If a trader has engaged in a longstraddle options strategy in thecompany that is being merged intothe other he has the option andright to exercise the call optionthat is half of his strategy.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  10. 10. This will allow him to buy thestock if he exercises prior to thedate at which shareholders mustchoose cash or the surviving stock.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  11. 11. Understanding the underlyingequities in this situation will allowthe trader to profit if having stockin the merged company isprofitable. It will also allow thetrader to let the call option expireunexercised if exercising would bea losing proposition.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  12. 12. Understanding underlying equities isas important as understanding strikeprices and spot prices in optionstrading. The spot price of an option isalways dependent upon the price ofthe underlying equity and the strikeprice is simply the spot price at thetime the option is offered.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  13. 13. Mergers are not the only event thatcan dramatically change the valueand potential of an optioncontract. Although regulardividends do greatly effect anoption large, one time, cashdistributions will.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  14. 14. If a cash distribution is announced andwill occur in the near future the holderof a call option will probably want toexercise the options contact justbefore the distribution unless thestock had dropped so far below thespot price that taking the distributionwould still result in a loss.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  15. 15. In recent years Microsoft gaveshareholders a huge one time cashdistribution. Microsoft was not introuble. Its share price simply hadnot been going up.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  16. 16. Anyone who is able to cash in onsuch a bonanza will find thatunderstanding underlying equitiesis very profitable.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  17. 17. On the other hand when acompany announces a huge cashdistribution for shareholders ofrecord on a previous date all thatthe trader can do is wish they hadexercised the option before thatdate.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  18. 18. Risk management in options tradingmay include avoiding buying optionswhere the underlying company is closeto bankruptcy. The promise of thissituation is that the company maysolve its problems before goingbankrupt or may become a takeovertarget and see its stock soar providingthe holder of a call option a tidy profit.By: www.options-trading-education.com/11072/understanding-underlying-equities/
  19. 19. If, on the other hand, the companygoes bankrupt it will typically thentrade on the over the counter market.The holder of an option can thenexercise the option and buy the stockwhich will then trade on the OTCmarket or simply close the position.Understanding underlying equitieswill help the trader avoid makingthese sorts of choices.By: www.options-trading-education.com/11072/understanding-underlying-equities/