What Is an Underlying Asset in Derivatives? Definition & Examples

What is an Underlying Asset

Underlying assets are the basic financial instruments or commodities that derivatives like options and futures are based on. The value of a derivative depends directly on the price or performance of its underlying asset, making these assets crucial in trading. Examples include stocks, bonds, commodities, or indexes.

Understanding the Fundamentals of Underlying Assets

Underlying assets give derivatives their value. For example, an option on stock XYZ allows the holder to buy or sell it at the strike price until expiration. The underlying asset here is XYZ stock. Many, but not all, stocks have option chains available.

An underlying asset identifies the item in the agreement that provides contract value. It supports the security involved, which parties agree to exchange as part of the derivative contract.

How Derivative Contracts Work with Underlying Assets

The price of an option or futures contract comes from the underlying asset's price. In an option contract, the writer must buy or sell the asset to the buyer on a specific date at the agreed price.  The buyer is not obligated to buy the asset, but they can exercise their right if desired. If the option is expiring and the asset hasn't moved favorably, the buyer can let it expire and lose only the amount paid for the option. 

Futures are obligations for both the buyer and seller. The seller agrees to provide the asset at expiry, and the buyer agrees to purchase it then. The price they receive and pay, respectively, is the price they entered the futures contract at. Most futures traders close positions before expiration, as retail traders and hedge funds rarely need physical assets like barrels of oil. But, they can buy or sell the contract at one price, and if it moves favorably they can exit the trade and make a profit that way. Futures are a derivative because the price of an oil futures contract is based on the price movement of oil, for example.

Real-World Examples of Underlying Assets in Action

In cases involving stock options, the underlying asset is the stock itself. For example, with a stock 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 is used to determine the value of the option up till expiration. The value of the underlying asset may change before the expiration of the contract, affecting the value of the option. The value of the underlying asset at any given time lets traders know whether the option is worth exercising or not.

The underlying asset could also be a currency or market index, such as the S&P 500. In the case of stock indexes, the underlying asset is comprised of the common stocks within the stock market index.

The Bottom Line

An underlying asset is what a derivative, like an option or future, is based on, and it affects the derivative’s value. Examples include stocks, commodities, currencies, and market indexes. As an investor, understanding underlying assets and how they work can help you make better investment decisions and manage risk.