What is an Underlying Asset?

An underlying asset is a security on which a derivative is based.

How Does an Underlying Asset Work?

For example, options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. For example, let's say you purchase a call option on shares of Intel (INTC) with a strike price of $40 and an expiration date of April 16. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16 (the right to do this, of course, will be valuable only if Intel is trading above $40 per share at that point in time).

The seller (writer) has the obligation to either buy or sell the underlying asset (depending on what type of option he or she sold -- either a call option or a put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an options contract has the right, but not the obligation, to complete the transaction by a specified date. When an option expires, if it is not in the buyer's best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future -- hence the name.

Why Does an Underlying Asset Matter?

Investors use options and the concept of underlying assets for two primary reasons -- to speculate and to hedge risk. When you purchase options to speculate on future stock price movements, you are limiting your downside risk, yet your upside earnings potential is unlimited.