What Does Underlying Security Mean?

An underlying security is an asset that a derivative instrument (e.g. futures, options) derives its value from. In essence, it’s a stock, bond, currency, commodity, index, or interest rate used as the basis of a derivative contract.

Underlying Security vs. Asset

Underlying asset is another term for underlying security. The underlying asset can be used to identify the basis of a derivative contract.

For example, an option contract for Stock ABC gives an investor the right to buy or sell it at the strike price until expiration. In this case, the underlying asset is Stock ABC.

Why Are Underlying Securities Important?

Underlying securities give derivatives (such as options) much of their value. Investors use options and the concept of underlying assets to speculate and hedge risk. For example, when you purchase options to speculate on future stock price movements, you are trying to limit your downside risk, while allowing for unlimited upside potential.

Common Examples of Underlying Securities

Call options are a common way that underlying securities are used. For example, if you purchase a call option for Amazon shares with a strike price of $50 and expiration date of November 30, you have the right to purchase a predetermined amount of shares by that time and at that price.

In this case, the Amazon shares are the underlying security and the call option is the derivative. The value or price of the option is derived from the price of Amazon shares. That said, the relationship between the underlying security (ie. Amazon shares) and the derivative (ie. call option) may not be linear.

The farther the current price of the underlying security is from the strike price, the less like an option’s price changes. A derivative contract can be drawn up so that the price may be inversely or directly correlated with the underlying security’s price.

For a call option, the seller/writer is bound to sell the Amazon shares to you at the agreed upon price by the expiration date. If you choose not to exercise this right, then the option will expire worthless. For a put option, the seller/writer is obligated to buy the shares if you choose to exercise and sell them.

Using Underlying Security to Your Advantage

While there are lots of both common and rare derivatives, all of them are based on an underlying security (or asset). The derivative’s price will be affected when an underlying security’s price moves up or down. It’s important to do your research so you can hedge against risk and use an option and its underlying security to your advantage.

A derivative position is “covered” if it consists of both the underlying security and the related option; a position is “naked” if it contains only the derivative. Covered positions are less risky to hold because you already own the underlying security at a known price. Should you have to fulfill option exercise, say by selling shares when a call option is exercised, your position has less risk if you already own the shares.