An underlying security represents a stock or bond on which derivative instruments—such as futures, ETFs, and options—are based. It is fundamental in determining how derivatives derive their value.
Key Takeaways
- An underlying security generally refers to a stock or bond involved in derivative instruments like futures, ETFs, and options.
- Usually, the underlying security is the asset delivered by one party in a derivative contract, to be accepted by the other party.
- Traders use derivatives for speculating on or hedging against future price movements of the underlying security.
Grasping the Concept of Underlying Security
In derivative terminology, the underlying security is often shortened to “the underlying.” It can be any asset, index, financial instrument, or even another derivative. For instance, collateralized debt obligations (CDOs) and credit default swaps (CDS)—notorious during the Financial Crisis of 2008—are derivatives depending on underlying assets.
The role of the underlying security is to simply be its own intrinsic asset. Without derivatives, traders would directly trade the underlying assets themselves. However, with derivatives, the underlying asset becomes the item that must be delivered and accepted under the contract—with exceptions seen in indexes or swaps involving cash settlements.
All derivatives are anchored by an underlying security or asset, fundamentally linking price movements of the underlying asset to affect the pricing of the derivative.
Example of Underlying Security
Consider purchasing a call option on Microsoft Corp. (MSFT). This call option grants the right, but not the obligation, to buy MSFT shares at a predetermined price within a set period. The value of this call option will generally rise as MSFT share prices increase, with MSFT serving as the underlying security.
The relationship between the underlying security and its derivatives is typically not linear—we see greater changes in the derivative price if the strike price of an out-of-the-money option deviates significantly from the current price of the underlying security. Additionally, derivative contracts may have prices that correlate directly (as in call options) or inversely (as in put options) with the underlying security’s price.
Traders utilize derivatives not only for speculation but also as a hedge against potential price changes in the underlying security. The complexity of a derivative often informs the level of speculation or hedging involved. For example, options on futures involve bets on both the future price of the futures contract and future price of the underlying asset itself.
Related Terms: Derivatives, Stock Options, Hedging, Speculation, Financial Instruments.
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## What does "Underlying Option Security" refer to in the context of options trading?
- [ ] The broker facilitating the trade
- [x] The financial instrument upon which an options contract is based
- [ ] The set expiry date of the options contract
- [ ] The transaction fees associated with the trade
## Which types of financial instruments can be considered an "Underlying Option Security"?
- [x] Stocks, indices, commodities, and currencies
- [ ] Only stocks
- [ ] Government bonds and treasury notes only
- [ ] Cryptocurrency exclusively
## What role does the "Underlying Option Security" play in determining the value of an options contract?
- [x] It serves as the primary basis for the option’s valuation
- [ ] It has no impact on the option's value
- [ ] It is only used to determine transaction fees
- [ ] It solely determines the option's expiration date
## How does price movement of the "Underlying Option Security" affect an options contract?
- [x] Changes in its price directly influence the profitability of an option
- [ ] It does not impact the profitability of an option
- [ ] Only upward movements affect an option's value
- [ ] Only downward movements affect an option's value
## When an option is "In-The-Money" (ITM), what does it imply about the "Underlying Option Security"?
- [ ] The underlying security has lower liquidity
- [ ] The option's premium is higher than usual
- [x] The price of the underlying security is favorably aligned with the option's strike price
- [ ] The underlying security has not shown any recent price movement
## What happens to the options contract if the "Underlying Option Security" is extremely volatile?
- [x] It may lead to higher premiums due to greater underlying price uncertainty
- [ ] The options contract is automatically nullified
- [ ] The volatility has no effect on the options contract
- [ ] The option expires immediately
## Can the "Underlying Option Security" be a stock index?
- [x] Yes, stock indices can be underlying securities for options
- [ ] No, only individual stocks can be underlying securities
- [ ] No, indices do not qualify as underlying securities
- [ ] Indices are combined with multiple securities and cannot be underlying securities
## What is the "strike price" in an options contract?
- [ ] The price at which the broker executes your trade
- [ ] The current market price of the underlying security
- [x] The price at which the holder has the right to buy or sell the underlying security
- [ ] The transaction fee required to enter the options contract
## If the "Underlying Option Security" is a commodity, what form can the option settlement take?
- [x] Either physical delivery of the commodity or cash-settlement
- [ ] Cash-settlement only
- [ ] Only physical delivery of the commodity
- [ ] Neither; options only apply to financial instruments like stocks
## In options trading, who primarily benefits from volatility in the "Underlying Option Security"?
- [ ] The issuer of the options contract
- [x] Options traders, due to greater chances of profitability from price swings
- [ ] Market regulators, who monitor trading volumes
- [ ] Stock exchanges, as it causes higher transaction fees
