What is an 'Underlying Security'

An underlying security is a stock, index, bond, interest rate, currency, or commodity on which derivative instruments, such as futures and options, are based. It is the primary component of how the derivative gets its value.

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

BREAKING DOWN 'Underlying Security'

There are many widely used and exotic derivatives, 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 derivative based upon it.

In 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. The infamous collateralized debt obligations (CDOs) and credit default swaps (CDS), which were front and center in the Financial crisis of 2008, are also derivatives that depend on the movement of an underlying.

Traders use derivatives to either speculate on or hedge against, the future price movements of the underlying. The more complex a derivative becomes, the more significant the degree of speculation and hedging become. For example, options on futures are bets on the future price of the futures contract, which in itself is a bet on the future price of the underlying.

The Role of the Underlying

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

The underlying is also crucial to the pricing of derivatives. The relationship between the underlying and its derivatives is not linear, although it can be. 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.

Also, the derivative contract may be written so that its price may be directly correlated, or inversely correlated, to the price of the underlying security. A call option is directly correlated. A put option is inversely correlated.

RELATED TERMS
  1. Underlying

    Underlying, in equities, refers to the common stock that must ...
  2. Derivative

    A derivative is a security with a price that is dependent upon ...
  3. Equity Derivative

    An equity derivative is a trading instrument which is based on ...
  4. Economic Derivative

    An economic derivative is an over-the-counter contract where ...
  5. Credit Derivative

    A credit derivative is a financial asset in the form of a privately ...
  6. Derivatives Time Bomb

    Derivatives time bomb is a descriptive term for a possible market ...
Related Articles
  1. Investing

    Complex Derivatives Made Simple

    Many ETFs hold derivatives. Here's how to be sure if you own a derivatives-based ETF.
  2. 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.
  3. Trading

    Examples Of Exchange-Traded Derivatives

    We look at some of the most common exchange-traded derivatives.
  4. Trading

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  5. Investing

    Did Derivatives Cause The Recession?

    We may never come to a consensus on what caused the financial collapse, but derivatives definitely share a large part of the blame.
  6. Trading

    What's the Strike Price?

    The strike price is the price at which a derivative can be exercised, and refers to the price of the derivative’s underlying asset. In a call option, the strike price is the price at which the ...
  7. Trading

    How Companies Use Derivatives to Hedge Risk

    Learn how derivatives can be used to reduce the risks associated with changes in foreign exchange rates, interest rates, and commodity prices.
  8. Investing

    Diamonds: The Missing Commodity Derivative

    While they may be "a girl's best friend", diamonds haven't made it to the futures market - yet.
  9. 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.
RELATED FAQS
  1. Are ETFs considered derivatives?

    Learn why most exchange-traded funds (ETFs) are not considered derivative securities and the special circumstances when this ... Read Answer >>
  2. 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 >>
  3. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  4. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Answer >>
  5. How are futures used to hedge a position?

    Futures contracts are one of the most common derivatives used to hedge risk. Learn how futures contracts can be used to limit ... Read Answer >>
Trading Center