What does 'Underlying' mean

Underlying, in equities, is the common stock that must be delivered when a warrant is exercised, or when a convertible bond or convertible preferred share is converted to common stock. The price of the underlying is the main factor that determines prices of derivative securities, warrants and convertibles. Thus, a change in an underlying results in a simultaneous change in the price of the derivative asset linked to it.

BREAKING DOWN 'Underlying'

There are two main types of investments: debt and equity. Debt must be paid back and investors are compensated in the form of interest payments. Equity is not required to be paid back and investors are compensated by share price appreciation or dividends. Both of these investments have specific cash flows and benefits depending on the individual investor.

Financial Derivatives

There are other financial instruments based solely on the movement of debt and equity. There are financial instruments that go up when interest rates go up. There are also financial instruments that go down when stock prices go down. These financial instruments are based on the performance of the underlying asset, or the debt and equity that is the original investment. This class of financial instrument is referred to as derivatives as it derives value from movements in the underlying. Generally, the underlying is a security such as a stock in the case of options, or a commodity in the case of futures.

An Underlying Example

Two of the most common types of derivatives are referred to as calls and puts. A call derivative contract gives the owner the right, but not the obligation, to buy a particular stock or asset at a given strike price. If company A is trading at $5 and the strike price is hit at $3, the price of the stock is trending up, the call is theoretically worth $2. In this case, the underlying is the stock priced at $5, and the derivative is the call priced at $2. A put derivative contract gives the owner the right, but not the obligation, to sell a particular stock at a given strike price. If company A is trading at $5 and the strike price is hit at $7, the price of the stock is trending down, the put is trading $2 in the money and is theoretically worth $2. In this case, the underlying is the stock priced at $5 and the derivative is the put contract priced at $2. Both the call and the put are dependent on price movements in the underlying asset, which in this case is the stock price of company A.

  1. Underlying Option Security

    An underlying option security is the financial instrument on ...
  2. Equity Derivative

    A derivative instrument with underlying assets based on equity ...
  3. Underlying Asset

    A term used in derivatives trading, such as with options. A derivative ...
  4. Energy Derivatives

    A derivative instrument in which the underlying asset is based ...
  5. Primary Instrument

    A primary instrument is a financial investment whose price is ...
  6. Derivative Product Company - DPC

    A special-purpose entity created to be a counter-party to financial ...
Related Articles
  1. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  2. Investing

    Complex Derivatives Made Simple

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

    SEC Derivatives Rule May Limit Diversification

    The SEC has proposed rules that will limit the use of derivatives by fund managers. Critics believe the rules will impede funds' ability to diversify.
  4. Personal Finance

    Careers in the Derivatives Market

    The growing interest in and complexity of derivatives means opportunities for job seekers.
  5. Trading

    Are Derivatives Safe For Retail Investors?

    These vehicles have gotten a bad rap in the press. Find out whether they deserve it.
  6. Investing

    Convertible bonds: pros and cons for companies and investors

    Learn about the pros and cons of convertible bonds – and what effect they have on investors.
  7. Trading

    5 Equity Derivatives And How They Work

    These derivatives allow investors to transfer risk, but there are many choices and factors that investors must weigh before buying in.
  8. Trading

    Are Derivatives A Disaster Waiting To Happen?

    They've contributed to some major market scandals, but these instruments aren't all bad.
  9. Investing

    An Introduction to Convertible Bonds

    Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex than they really are.
  10. Investing

    Understanding warrants and call options

    Warrants and call options are securities that are quite similar in many respects, though they have some notable differences.
  1. What does the underlying of a derivative refer to?

    Find out more about derivative securities, what an underlying asset is and what the underlying assets refer to in stock options ... Read Answer >>
  2. What expiry months are typically available for derivatives?

    Discover more about the derivatives market and learn about the varying expiration months for derivatives in different financial ... Read Answer >>
  3. What does it mean to take delivery of a derivative contract?

    Find out more about derivative contracts and what it means when the holders of derivative contracts take delivery of the ... Read Answer >>
  4. How can derivatives be used for speculation?

    Find out more about derivative securities, speculation and how derivatives could be used to speculate on the price of the ... Read Answer >>
Hot Definitions
  1. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  2. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  3. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  4. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  6. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
Trading Center