An underlying security is a stock or bond on which derivative instruments, such as futures, ETFs, and options, are based. It is the primary component determining the value of the derivative.
Key Takeaways
- An underlying security is a stock or bond on which derivative instruments like futures, ETFs, and options are based.
- In many cases, the underlying security must be delivered by one party in the derivative contract and accepted by the other party.
- Traders use derivatives to either speculate on or hedge against future price movements of the underlying security.
Unveiling the Essence of Underlying Security
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 central to the Financial Crisis of 2008, are derivatives that depend on the movement of an underlying. Not every stock will have an underlying option chain.
The role of the underlying security is essentially to serve as the foundational asset. If there were no derivatives, traders would simply buy and sell the underlying asset. However, for derivatives, the underlying security must be delivered by one party in the derivative contract and accepted by the other, except when the underlying is an index, or the derivative is a swap where cash is exchanged instead.
There are numerous derivatives, both common and exotic, but they all share one commonality—their value is based on an underlying security or asset. Price movements in the underlying security will inevitably affect the pricing of the derivative.
For instance, a call option on Alphabet, Inc. (GOOGL) stock gives the holder the right, but not the obligation, to purchase Alphabet stock at a price specified in the options contract. In this context, Alphabet stock is the underlying security.
Traders employ derivatives to either speculate on or hedge against future price changes of the underlying asset. The complexity and risk associated with derivatives can be substantial; for example, options on futures are bets on the future price of the futures contract, which in themselves are bets on the future price of the underlying security.
Underlying Security Example: Microsoft Corporation (MSFT)
Imagine considering a call option on Microsoft Corp. (MSFT). Buying a call gives you the right to purchase MSFT shares at a defined price within a specific period. Generally, the value of the call option rises as the share price of MSFT increases. The call option is a derivative, and its price is tethered to the price of MSFT, making MSFT the underlying security.
The pricing of derivatives is deeply intertwined with the underlying asset. Although not always linear, the shielding and sensitivity to price changes depend on how the contract is structured. For example, an out-of-the-money option with a more distant strike price generally changes less per unit of movement in the underlying asset.
Furthermore, the relationship between a derivative’s price and its underlying asset can be either directly correlated or inversely correlated. A call option is typically directly correlated with the underlying asset’s price, while a put option is inversely correlated.
Related Terms: Futures, ETFs, Options, Swap, Speculation, Hedging.
