Underlying Asset (Derivatives)—Definition, How It Works, Examples

What is an Underlying Asset

Underlying assets are the financial assets on which a derivative’s price is based. Options are an example of a derivative, which is a financial instrument with a price based on a different asset.

The Basics of Underlying Asset

Underlying assets give derivatives their value. For example, an option on stock XYZ gives the holder the right to buy or sell XYZ at the strike price until expiration. The stock of XYZ is the underlying asset for the option.

An underlying asset identifies the item that provides value to the contract. It supports the security involved in the agreement and is exchanged as part of the derivative contract.

Understanding Derivative Contracts

The price of an option or futures contract is derived from the price of an underlying asset. In an option contract, the writer must buy or sell the underlying asset to the buyer on the specified date at the agreed-upon price. The buyer is not obligated to purchase the underlying asset but can choose to exercise their right. If the option is about to expire and the underlying asset has not moved favorably enough to make exercising the option worthwhile, the buyer can let it expire and lose the amount paid for the option.

Futures are obligations for both the buyer and the seller. The seller agrees to provide the underlying asset at expiry, and the buyer agrees to buy the underlying at expiry. The respective prices are based on the price entered into the futures contract. Most futures traders close out their positions before expiration, as they don’t need physical possession of the asset. They can buy or sell the contract at one price and exit the trade to make a profit if it moves favorably. Futures are derivatives based on the price movement of the underlying asset, such as oil.

Key Takeaways

• Underlying assets represent the assets from which derivatives derive their value.
• Knowing the value of an underlying asset helps traders determine the appropriate action with their derivative.

Example of an Underlying Asset

In cases involving stock options, the underlying asset is the stock itself. For example, with an option to purchase 100 shares of Company X at a price of $100, the underlying asset is the stock of Company X. The underlying asset determines the value of the option until expiration. The value may change before the contract expires, affecting the option’s value. Traders assess the value of the underlying asset to decide whether exercising the option is worthwhile or not.

The underlying asset can also be a currency or market index, like the S&P 500. Stock indexes consist of the common stocks within the stock market index.