What is an Underlying Option Security

An underlying option security is a stock, index, bond, currency, or commodity on which an option's value is based. It is the primary component of how the option gets its value.

BREAKING DOWN Underlying Option Security

For example, a call option on Apple (symbol AAPL) stock gives the holder the right, but not the obligation, to purchase Apple stock at a price specified in the option contract. In this case, Apple stock is the underlying security.

There are many widely used and exotic derivatives, including options, but they all have one item in common, which is their basis on an underlying security or underlying asset. Price movements in the underlying security will necessarily affect the pricing of the option based upon it.

In options, and all derivative terminology, the underlying security is often referred to simply as "the underlying." An underlying security can be any asset, index, financial instrument, or even another derivative.

Traders use options to either speculate on or hedge against, the future price movements of the underlying. Options used in combination can further refine the characteristics of the strategy to meet specific needs. 

The Role of the Underlying

The apparent role of the underlying security is merely to be itself. If there were no options, traders would simply buy and sell the underlying. However, when it comes to options, the underlying is the item which must be delivered by one party in the options contract and accepted by the other party. The exception is when the underlying is an index, where only cash is exchanged at the end of the options contract.

The underlying is also crucial to the pricing of options. The relationship between the underlying and its options is not linear, although some options strategies can hedge away certain options characteristics to simulate a linear relationship. In options pricing models, there are several characteristics that describe the degree of non-linearity, called the Greeks, because they are represented by various Greek letters.

For example, the more distant the strike price for an out-of-the-money option is from the current price of the underlying, the less the option price changes per unit of move in the underlying. In this case, the option has a low delta value.

The same is true for options that have a lot of time left until maturity. This is measured by theta. As expiration approaches, time decay increases exponentially.

Conversely, options that are in-the-money and very near to expiration will move almost in lock step with the underlying.