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.
