Underlying Security

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Underlying Security

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, ETFs, and options, are based. It is the primary component of how the derivative gets its value.

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

How an Underlying Security Works

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.

Example of an Underlying Security

Let’s say we are interested in buying a call option on MSFT. Buying a call gives us the right to buy shares of MSFT at a determined price and time. Generally speaking, the value of the call option will increase alongside an increase in the share price of MSFT. Because the call option is a derivative, its price is tied to the price of MSFT. MSFT in this case is the underlying security.

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. Generally speaking 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 movement 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.

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Underlying

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.

Understanding Underlying

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.

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 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.

Underlying security

Underlying security

Underlying Security

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