Wednesday, June 23rd, 2021

Understanding Underlying Equities

July 5, 2013 by Jim Walker  
Filed under Options Trading Tips

When trading options, trading futures, buying convertible bonds, engaging in equity swaps, or trading exchange traded derivatives, understanding underlying equities is basic to success. The market in the overlying option, future, etc. is dependent upon the market in underlying equity. 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. 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.

The underlying security of an option is usually common stock but it can be American Depository Receipts (ADR’s), preferred stock, or other instruments. 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. For example, in a merger some shareholders may elect to receive cash and others may elect to receive shares of the surviving company. 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. 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. 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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