Underlying Security: What it Is and How It Works

An underlying security is the asset, instrument, or index on which a derivative’s value is based. Common underlyings include stocks, bonds, commodities, currencies, and indexes. Even other derivatives can serve as underlyings for more complex products.

Key takeaways

• The underlying security is the item whose price movements determine a derivative’s value.
• Derivatives include options, futures, swaps, and other structured products; some contracts require physical delivery of the underlying, while others are cash‑settled.
• Traders use derivatives to speculate on or hedge against future moves in the underlying.
• The relationship between an underlying and its derivative is often nonlinear and affected by strike, time to expiration, volatility, and other factors.

How the underlying security drives derivatives

Derivatives derive their price from the underlying asset. For contracts that call for delivery, one party provides the underlying and the counterparty accepts it at contract maturity. For cash‑settled contracts (common with indexes and many swaps), only a cash payment tied to the underlying’s price is exchanged.

Price changes in the underlying translate into changes in the derivative’s price, but the magnitude and direction depend on the derivative type and contract terms. For example:
* A call option is positively correlated with the underlying: as the underlying rises, the call’s value generally increases.
* A put option is negatively correlated: as the underlying rises, the put’s value generally decreases.

Nonlinear behavior and pricing drivers

The derivative–underlying relationship is not always one‑to‑one. Factors that affect how a derivative responds to movements in the underlying include:
* Strike price relative to the underlying (in‑, at‑, or out‑of‑the‑money)
* Time to expiration (more time usually increases option value)
* Implied volatility (higher volatility typically raises option prices)
* Interest rates and dividends (can influence futures and option pricing)

For options, “delta” measures how much the option price is expected to change for a small move in the underlying. Out‑of‑the‑money options often have low delta, so their prices change less per unit of underlying movement than near‑the‑money options.

Examples

• Call option on Microsoft (MSFT): Buying a call grants the right (not the obligation) to purchase MSFT at a specified strike price before expiration. MSFT is the underlying; if MSFT’s share price rises, the call generally becomes more valuable.
• Options on futures: These are options whose underlying is a futures contract, which itself is a contract based on a physical commodity, financial instrument, or index.
• Credit derivatives: Products like credit default swaps (CDS) and collateralized debt obligations (CDOs) are tied to debt instruments as their underlying exposures.

Practical uses

• Hedging: An investor with a long position in an asset can buy puts or sell futures to protect against downside risk.
• Speculation: Traders can use options or futures to take leveraged bets on the future direction of an underlying without owning it.
• Income and strategies: Option writing and structured products use the underlying to generate yield or shape payoff profiles.

Conclusion

The underlying security is the foundational element of any derivative. Understanding what serves as the underlying and how its price dynamics affect derivative pricing is essential for using derivatives effectively—whether for hedging, income generation, or speculation.