What Does Underlying Mean?
Underlying, when referred to in reference to equity trading, 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 the prices of derivative securities, warrants, and convertibles. Therefore, a change in the price of the underlying results in a simultaneous change in the price of the derivative asset linked to it.
Underlying applies to both equities and derivatives. In derivatives, underlying refers to the security that must be delivered when a derivative contract, such as a put or call option, is exercised.
There are two main types of investments: debt and equity. The 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.
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 instruments 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.