What it is:
An underlying security is a security on which ais based.
How it works/Example:
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 .
For example, let's say you purchase a call option on of Intel (Nasdaq: INTC) with a strike price of $40 and an date of April 16. This 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, be valuable only if Intel is trading above $40 per share at that point).
The seller (writer) has the to either buy or sell the underlying security (depending on what type of option he or she sold -- either a call option or a ) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an 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 it matters:
Underlying securities are what give options and much of their value. Investors use options and the concept of for two primary reasons: to speculate and to risk. When you purchase options to speculate on future price movements, you are limiting your , yet your potential is unlimited.