What Is Underlying Security?
Let me explain what an underlying security is—it's simply a stock or bond that serves as the foundation for derivative instruments like futures, ETFs, and options. This underlying element is what gives the derivative its value, acting as the primary component in the whole setup.
Key Takeaways
You should know that an underlying security is the stock or bond underpinning derivatives such as futures, ETFs, and options. In most scenarios, it's the item that one party in the derivative contract must deliver, and the other must accept. Traders rely on these derivatives to speculate on or hedge against future price shifts in the underlying security.
Understanding Underlying Security
In the world of derivatives, we often just call the underlying security 'the underlying.' It can be any asset, index, financial instrument, or even another derivative. Think about the collateralized debt obligations (CDOs) and credit default swaps (CDS) that played a big role in the 2008 financial crisis—they're derivatives tied to an underlying's movement. Not every stock comes with its own option chains, by the way.
The underlying's job is straightforward: it just exists as itself. Without derivatives, you'd buy and sell the underlying directly. But with derivatives, it's what one party delivers and the other accepts in the contract—unless it's an index or a swap, where only cash changes hands at the end.
All derivatives, whether common or exotic, share this: they're based on an underlying security or asset. Any price change in the underlying directly impacts the derivative's price.
Take a call option on Alphabet, Inc. (GOOGL) stock, for instance—it gives you the right, but not the obligation, to buy Alphabet shares at a set price in the contract. Here, Alphabet stock is the underlying security.
You use derivatives to bet on or protect against future price moves in the underlying. The more complex the derivative, the greater the speculation or hedging involved. Options on futures, for example, are wagers on the futures contract's future price, which itself wagers on the underlying's future price.
Underlying Security Example
Suppose you're looking to buy a call option on Microsoft Corp. (MSFT). This gives you the right to purchase MSFT shares at a specific price over a set period. Typically, if MSFT's share price rises, so does the call option's value. Since the call is a derivative, its price is linked to MSFT's price—making MSFT the underlying security.
The underlying is key to how derivatives are priced. The connection isn't always linear, though it can be. For out-of-the-money options, if the strike price is far from the underlying's current price, the option's price shifts less per unit change in the underlying.
Derivative contracts can be set up for direct or inverse correlation with the underlying's price. A call option correlates directly, while a put option correlates inversely.
Other articles for you
A waiver of premium rider is an optional life insurance add-on that waives premium payments if the policyholder becomes disabled or critically ill.
Hammering refers to the rapid selling of stocks following unexpected negative events, causing sharp price declines, with potential for recovery as seen in patterns like the hammer candlestick.
A distribution channel is the network of intermediaries that gets a product or service from producer to consumer.
Intrinsic value represents the true worth of an asset based on fundamental factors, distinct from its market price, and is used in stock and options analysis to identify investment opportunities.
The Nordic model is a socio-economic system in Scandinavian countries that blends capitalism with extensive social welfare funded by high taxes.
This text explains the various meanings and applications of 'spread' in finance, covering stocks, bonds, lending, options, and forex.
Real income measures an individual's or entity's earnings adjusted for inflation to reflect true purchasing power.
An incumbency certificate is a corporate document listing authorized directors, officers, and key shareholders for legal transactions.
This page from Investopedia explores tech stocks as key economic indicators, featuring articles on major tech companies, investments, and industry definitions.
Vomma measures how an option's vega changes with market volatility.
Other articles for you
Tax-equivalent yield helps investors compare taxable and tax-exempt bond returns based on their tax bracket.
The spot market is where assets like commodities, currencies, and securities are traded for immediate payment and delivery, contrasting with futures markets.
Water rights are legal entitlements for property owners to access and use adjacent bodies of water, varying by region and type in the US.
The Dogs of the Dow is an investment strategy that selects the 10 highest dividend-yielding stocks from the DJIA annually to potentially outperform the index.
Asset/liability management is the practice of managing a company's assets and cash flows to minimize risks associated with meeting liabilities on time.
A personal identification number (PIN) is a numerical code that enhances security in electronic financial transactions, especially with payment cards.
An income property is real estate bought or developed to generate rental income and potential appreciation, involving considerations like risks, mortgages, and management.
A target market is a specific group of consumers most likely to buy a product based on shared characteristics like demographics, lifestyle, and behaviors.
This text is a comprehensive resource on investing in the UK, covering products, strategies, key terms, financial systems, and retirement planning.
Tax-advantaged investments and accounts offer tax benefits like deferrals or exemptions to help minimize your tax burden and grow wealth.