Learn about underlying assets, how they work, and what they can do for you as an investor.
Definition and Examples of an Underlying Asset
Underlying assets are the assets that influence the value of a derivative security. In other words, derivatives “derive” their value from their underlying asset.
Alternate name: Underlier, underlying, underlying interest, underlying security
In the case of stock options, the underlying asset is the stock itself. Let’s say you purchase a call option at the $100 strike price for Company XYZ. The underlying asset is the stock valued at $100. This call option gives you the right to buy the equity at $100 by the deadline. If the stock is trading at $110 before the deadline, you can execute your right to purchase it at $100—the value of the underlying asset.
How Does an Underlying Asset Work?
There is a direct relationship between a derivative and its underlying security. “The price movements of a derivative security are directly related to the price movements of the underlying asset,” Dr. Robert R. Johnson, a finance professor at Creighton University’s Heider College of Business told The Balance in an email. “That is, the buyer of a call option on Tesla stock gains when the value of Tesla stock rises and loses when the value of Tesla stock falls.” Some investors that trade derivatives use futures contracts to mitigate risk. A futures contract allows the investor to lock in a price for, say, a commodity like corn, by a specified deadline. The value of the contract is based on the underlying asset: corn. Johnson provided an example of how this concept might work for a farmer. “A farmer who grows corn has a natural long position in corn,” Johnson said. “That farmer may want to lock in a price for [their] corn at harvest instead of simply waiting and seeing what the market price will be at the time [the farmer] harvests the corn. In that case, the farmer might sell corn in the futures market, guaranteeing the price [they] will receive.”Whether the future price is higher or lower than the locked-in price determines the profit or loss for the farmer. “If at the time of harvest the price of corn is lower than that at which [the farmer] contracted to sell, [they] would have won by selling the futures contract,” he said. “If the price is higher, [they] would have been better off not selling corn futures and [getting the] higher market price.”
What It Means for Individual Investors
Understanding underlying assets is critical to investors who want to engage in derivatives trading, whether it be options contracts or futures contracts. Derivatives trading isn’t easy and the losses can be substantial, so they aren’t recommended for beginning investors. “The quality of the derivatives market that is attractive—and also dangerous—to investors is that derivatives markets allow investors to leverage their positions,” Johnson said. “Investors can use margin to control a larger pool of assets with a smaller amount of money. In the stock market, investors can control $100,000 worth of securities with $50,000.” But what makes the derivatives market attractive to investors comfortable with risk is the increased leverage they achieve, Johnson said. “In the derivative markets, the leverage factor is much higher,” he said. “For instance, in the foreign exchange markets, leverage is commonly as high as 100 to 1. That is, you can control up to $100 in foreign currency for every dollar of equity in your account.” Understanding how the markets will shift will affect your profitability in the derivatives market. “Leverage is terrific when markets move in the direction you anticipate,” Johnson said. “ But, if markets move against you, with leverage, you can lose money very quickly.”
