Table of Contents

Underlying Security



Definition

An underlying security is a stock, bond, commodity, or any other asset upon which a derivatives contract, such as a futures or options contract, is based. It is the asset that the derivative seller has the obligation to deliver to or buy from the derivative buyer, on or before a specified date. The price of the derivative often depends on the price performance of this underlying security.

Phonetic

The phonetic pronunciation of the term “Underlying Security” is:Un·der·ly·ing Se·cu·ri·ty, /ˈʌndərˌlaɪɪŋ sɪˈkyʊərɪti/

Key Takeaways

Underlying Security plays a fundamental role in the world of finance, particularly in derivatives trading. It’s critical to understand key aspects of Underlying Security. Here are three main takeaways:

  1. Definition: Underlying Security refers to the financial asset (such as stocks, commodities or bonds) upon which a derivative’s price is based. It’s the asset that must be delivered when a derivative contract, like a put or call option, is exercised.
  2. Role in Derivatives: Derivatives derive their value from Underlying Securities. The performance and fluctuation of an Underlying Security directly affects the value of the associated derivative. Using derivatives, investors can speculate on future price movements of Underlying Securities without actually owning the asset.
  3. Risk Management: Underlying Securities allow for risk management strategies in investment. By buying derivatives linked to Underlying Securities, investors are able to hedge against potential losses, which may occur due to adverse price movements in these Underlying Securities.

Importance

Underlying Security is a crucial term in business and finance as it forms the foundation of various derivative products such as options, futures, and other financial instruments that derive their value. It refers to the specific financial asset (like stocks, bonds, commodities, currencies, etc.) that these instruments are built upon. This concept is pivotal because it helps to assess the risk and reward scenario of the derivative investment. The price and the performance of the underlying security directly influence the value of the derivatives. Therefore, understanding the underlying security can lead to more informed investment decisions about buying or selling these financial instruments.

Explanation

The underlying security serves a critical function in the world of finance and investing, particularly within derivatives trading. Essentially, an underlying asset is utilized as a benchmark to establish the price level or settlement conditions for derivatives such as options, futures contracts, and swap contracts. These financial contracts allow investors to speculate on the pricing fluctuations of the underlying security without necessarily owning it, thereby enabling them to participate in various markets and manage risk effectively. When a derivative is purchased, it’s not the actual security that is bought; instead, it’s a contract that derives its value from the price movement of the underlying security. For example, an option gives the holder the right (but not the obligation) to buy or sell the underlying security at a specified price within a certain time frame. Hence, underlying securities are used to determine the value and potential payoff of these derivatives. In effect, they allow for a broader range of investment strategies beyond straightforward buying or selling of securities, providing opportunities for hedging, leverage, and speculation.

Examples

1. Shares in a Company: In options contracts, the underlying security often refers to the specific shares in a business. For example, if an investor purchases a call option for Tesla, Inc. (TSLA), the underlying security for the option contract is specifically the shares of Tesla, Inc. The investor has the right (but not obligation) to purchase these shares at a predetermined price (strike price) until the option’s expiration date. 2. Treasury Bonds: Treasury bonds (T-Bonds) can be an underlying security for futures contracts. For example, the Chicago Board of Trade (CBOT) offers a futures contract on U.S. Treasury bonds. In this case, the obligated party will have to deliver the specific bond upon the contract’s expiration. 3. Exchange-Traded Funds (ETFs): ETFs are often the underlying security for options contracts. SPDR S&P 500 ETF Trust (SPY) is one example where it represents the underlying security for related options contracts. The contract gives the holder the right to buy or sell the ETF shares at a specific price before the contract expires.

Frequently Asked Questions(FAQ)

What is an Underlying Security?
An Underlying Security is a stock, bond, commodity, currency, or any other asset on which derivatives or other securities are based. It is the asset that must be delivered when a derivative contract, like an option, is exercised.
Why is the Underlying Security important in derivative trading?
The Underlying Security is important in derivative trading as its price and volatility determine the profitability of the derivative. Investors use derivatives to hedge risk or to speculate on the price movement of the Underlying Security.
How is the value of the Underlying Security determined?
The value of the Underlying Security is determined by the market, through supply and demand dynamics. Factors such as economic indicators, company earnings, and geopolitical events can also affect the value of the Underlying Security.
Can an Underlying Security be a combination of assets?
Yes, an Underlying Security can be a single asset or a combination of assets. For instance, in index options trading, the Underlying Security consists of all the stocks that make up a specific index.
Is it necessary to own the Underlying Security to trade derivatives?
No, it’s not necessary to own the Underlying Security to trade derivatives. However, the owner of a derivative contract may be obligated to purchase the Underlying Security if the contract is exercised.
How is the price of a derivative related to the price of the Underlying Security?
The price of a derivative is directly related to the price of its Underlying Security. As the price of the Underlying Security goes up, the price of call options will increase and the price of put options will decrease. The opposite is true if the price of the Underlying Security decreases.
Are the risks associated with trading derivatives the same as trading the Underlying Security?
No, the risks associated with trading derivatives and the Underlying Security are not the same. Derivatives can be highly leveraged instruments, meaning they can lead to large profits or losses, relative to the amount invested, making them riskier than trading the Underlying Security directly.

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