What is an Underlying Security?

An underlying security is a type of asset that is used as the basis for the creation and trading of derivatives. Derivatives are financial instruments whose value or price is derived from one or more underlying assets. Common derivatives include futures, options, ETFs and swaps.

Underlying securities are typically stocks, bonds or commodities, and are known as the "underlying asset" in a derivatives contract. Derivatives are financial instruments that derive their value from the price movements or performance of the underlying asset. Traders use derivatives to either speculate on, or hedge against, the future price movements of the underlying security.

For example, if we have a stock option contract on company X, company X’s stock is the underlying security. When one party buys the option, the other is going to receive the right to sell the underlying security (in this case company X’s stock) at a preset cost. If the trader buys a futures contract on gold, the underlying security is physical gold.

Underlying securities are typically delivered by one party in the derivative contract and accepted by the other party at the expiration of the derivatives contract, when the other party receives the right to settle the contract at an agreed price. The delivery or acceptance of the underlying security is the primary purpose of derivatives trading.

From the investor’s point of view, it is essential to know the underlying security when trading derivatives. Knowing the underlying security is integral to understanding how the derivative will respond in various market conditions. For instance, if the underlying security is a commodity, its price can be affected by weather, natural disasters, economic events and other factors. However, if the underlying security is a stock, its price movements might be affected by a different set of factors, such as positive and negative news around the stock, developments in its sector and dividend payments.

Generally speaking, the inherent risk associated with a derivative instrument increases with the complexity of the underlying asset class. As such, investors need to be aware of the risks associated with the underlying security before they decide to enter into derivatives trading.