Loading the player...

What is an 'Underlying Asset'

Underlying asset is a term used in derivatives trading. Options are an example of a derivative. A derivative is a financial instrument with a price that is based on a different asset. The underlying asset is the financial instrument on which a derivative's price is based. 

Breaking Down 'Underlying Asset'

Underlying assets give derivatives their value. For example, an option on stock XYZ gives the holder the right to buy or sell XYZ at the strike price up until expiration. The underlying asset for the option is the stock of XYZ.

An underlying asset can be used to identify the item within the agreement that provides value to the contract. The underlying asset supports the security involved in the agreement, which the parties involved agree to exchange as part of the derivative contract.

Example of an Underlying Asset

In cases involving stock options, the underlying asset is the stock itself. For example, with a stock option to purchase 100 shares of Company X at a price of $100, the underlying asset is the stock of Company X. The underlying asset is used to determine the value of the option up till expiration. The value of the underlying asset may change before the expiration of the contract, affecting the value of the option. The value of the underlying asset at any given time lets traders know whether the option is worth exercising or not.

The underlying asset could also be a currency or market index, such as the S&P 500. In the case of stock indexes, the underlying asset is comprised of the common stocks within the stock market index.

Understanding Derivative Contracts

The price of an option or futures contract is derived from the price of an underlying asset. In an option contract, the writer must either buy or sell the underlying asset to the buyer on the specified date at the agreed-upon price. The buyer is not obligated to purchase the underlying asset, but they can exercise their right if they choose to do so. If the option is about to expire, and the underlying asset has not moved favorably enough to make exercising the option worthwhile, the buyer can let the expire and they will lose the amount they paid for the option.

Futures are an obligation to the buyer and a seller. The seller of the future agrees to provide the underlying asset at expiry, and the buyer of the contract agrees to buy the underlying at expiry. The price they receive and pay, respectively, is the price they entered the futures contract at. Most futures traders close out their positions prior to expiration since retail traders and hedge funds have little need to take physical possession of barrels of oil, for example. But, they can buy or sell the contract at one price, and if it moves favorably they can exit the trade and make a profit that way. Futures are a derivative because the price of an oil futures contract is based on the price movement of oil, for example.

RELATED TERMS
  1. Options On Futures

    An option on futures gives the holder the right, but not the ...
  2. Equity Derivative

    An equity derivative is a trading instrument which is based on ...
  3. Underlying Security

    An underlying security is a stock, bond, currency, or commodity ...
  4. Underlying Option Security

    An underlying option security is the financial instrument (stock, ...
  5. Exercise

    To put into effect the right specified in a contract. In options ...
  6. Digital Option

    Digital options have a fixed payout and risk, are based on price ...
Related Articles
  1. Trading

    A Quick Guide To Debt Options

    Options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility, learn more today.
  2. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  3. Trading

    Option trading strategies: A guide for beginners

    Options offer alternative strategies for investors to profit from trading underlying securities. Learn about the four basic option strategies for beginners.
  4. Trading

    An Overview Of Futures, Derivatives, and Liquidity

    Gain an understanding of futures and derivatives, and how these instruments are meant to mitigate market risk.
RELATED FAQS
  1. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
  2. What is the difference between a long position and a call option?

    Learn what a long position in a stock is, what a call option is, and the difference between owning shares of a company and ... Read Answer >>
  3. Does the seller (the writer) of an option determine the details of the option contract?

    The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between ... Read Answer >>
Trading Center