What Is Underlying?

What Is Underlying?

Let me explain what underlying means in equity trading. It's the common stock you have to deliver when you exercise a warrant, or when you convert a convertible bond or preferred share into common stock.

The price of this underlying is the key driver for the prices of derivative securities, warrants, and convertibles. So, if the underlying's price changes, you'll see a corresponding shift in the price of the linked derivative asset.

Key Takeaways

Underlying is the security or asset you deliver when exercising a contract or warrant. In derivatives, it's what provides the cash flow to the derivative. It can be an asset, index, or even another derivative. For convertibles, it's the stock you exchange for the note. And remember, underlying assets are usually less volatile than their derivatives.

Understanding Underlying

Underlying applies to both equities and derivatives. Derivatives are built around the price or value of another asset, like a stock price—that stock is the underlying. When the underlying stock price rises, the derivative's market price might go up or down too.

In futures, the underlying is a commodity like gold, oil, or wheat. Disruptions in those commodity markets will impact the futures tied to them.

Convertibles work similarly, with derivative-like features. They're debts repaid like bonds, or under certain conditions, in company shares. The shares' value affects the convertible, so those shares are the underlying.

Tip

While we often talk about assets as underlyings, it can also be an interest rate, a benchmark, or another derivative.

Financial Derivatives

You'll see 'underlying' most in derivative contracts, which are structured around another asset. Options are a popular type, where traders bet on future prices of stocks or commodities. If the contract terms are met, you profit.

But the underlying isn't always an asset—it could be a benchmark index, interest rate, or financial metric. Changes in that metric affect the derivative's price. It can even be another derivative.

For example, many interest rate swaps use the secured overnight financing rate (SOFR) to exchange cash flows. If SOFR rises, the swap's value changes.

Pros and Cons of Underlying

When you invest in derivatives, understand the underlying asset or index's characteristics. Each has its own risks—stocks with investment risk, bonds with default risk, derivatives with market risk.

Underlyings are generally less volatile than derivatives. A call or put option might drop to zero near expiration, but stocks rarely lose all value.

Using an asset as an underlying in derivatives or futures adds liquidity and volume to its market, beyond what's in the spot market. For instance, trading options creates obligations to buy or sell the underlying, boosting market liquidity.

The downside is that speculation in derivatives can harm the underlying. In the 2007 housing crisis, speculative trading in mortgage-backed securities inflated and then crashed real estate prices.

Types of Underlyings

Underlyings vary by derivative contract. Equities can be individual stocks or indices, like Apple shares in options. Commodities include gold, oil, wheat—contracts let you speculate or hedge, with possible delivery.

Currencies involve forex pairs, like EUR/USD. Interest rates base on bonds or benchmarks, with the rate itself as underlying in swaps. Indices are baskets like the S&P 500.

Real estate can be properties or REITs for easier trading. Cryptocurrencies like Bitcoin have futures and options tied to their prices.

Limitations of Underlyings

Derivatives couldn't exist without underlyings, but there are constraints. Illiquidity in a security can alter derivative values. Some markets allow manipulation of the underlying.

Logistical issues arise with commodities—storage and delivery are challenges. For physical assets, you deal with storage, insurance, protection against obsolescence or theft.

Digital underlyings like cryptocurrencies face hacking, fraud, and technical failures, despite cybersecurity. They offer efficiencies but unique risks.

Example of Underlying

Consider calls and puts, common derivatives. A call gives you the right to buy a stock at a strike price. If Company A trades at $5 and strike is $3, the call is worth about $2—the stock is the underlying.

A put lets you sell at the strike. If strike is $7 and stock is $5, the put is worth $2. Both depend on the underlying stock's price movements.

What Happens When the Price of an Underlying Asset Increases?

Price changes in the underlying typically cause changes in derivatives. For a call, if the stock rises $3 above strike, the option is worth about $3. If it falls below at expiration, the option is worthless.

Is a Share an Underlying Asset?

Yes, shares can be underlyings if derivatives are built around them. They're common for calls, puts, or convertible debt convertible to shares under conditions.

What Are the Primary Underlying Assets?

Primary ones are stocks, commodities, bonds, and currencies. But derivatives can have abstract underlyings like interest or benchmark rates.

The Bottom Line

Underlyings are the assets or securities giving value to derivatives—from equities and commodities to currencies, rates, indices, or real estate. They form the foundation of these financial instruments.