What is an Underlying Asset
Let me explain what an underlying asset is. It's the financial asset that a derivative's price is based on. Take options, for example—they're a type of derivative, which means their value comes from another asset entirely.
Key Takeaways
You need to know that underlying assets are what give derivatives their value. If you understand the underlying asset's value, you can figure out the right move—whether to buy, sell, or hold—with your derivative.
The Basics of Underlying Asset
Underlying assets are what give derivatives their worth. For instance, if you have an option on stock XYZ, that gives you the right to buy or sell XYZ at the strike price until it expires. The underlying asset here is the XYZ stock itself. You'll find option chains on many stocks, but not all of them.
Think of the underlying asset as the item in the contract that provides the value. It backs the security in the agreement, and both parties agree to exchange it as part of the derivative deal.
Understanding Derivative Contracts
The price of an option or futures contract comes directly from the underlying asset's price. In an option contract, the writer has to buy or sell the underlying asset to the buyer at the agreed price on the specified date. But you, as the buyer, aren't forced to do anything—you can exercise your right if it makes sense. If the option is expiring and the underlying hasn't moved in your favor, just let it expire; you'll only lose what you paid for it.
Futures are different because they're an obligation for both sides. The seller must deliver the underlying asset at expiry, and the buyer must purchase it. The price is whatever you agreed on when entering the contract. Most traders close positions before expiration—retail traders and hedge funds don't usually want physical delivery of something like oil barrels. They buy or sell at one price, and if it moves favorably, they exit for a profit. Futures are derivatives because their price depends on the underlying, like oil's price movement.
Example of an Underlying Asset
When it comes to stock options, the underlying asset is the stock. Say you have an option to buy 100 shares of Company X at $100—the underlying is Company X stock. That underlying determines the option's value until expiration. If the underlying's value changes before the contract ends, it affects the option's value. At any point, the underlying's current value tells you if exercising the option is worth it.
The underlying could also be a currency or a market index like the S&P 500. For stock indexes, it's made up of the common stocks in that index.
