Underlying assets can be used to identify the items in an agreement that provide value to the contract. The underlying asset backs the securities involved in the agreement, which the parties agree to exchange as part of a derivatives contract.

Understanding Derivatives Contracts

The price of an option or futures contract is derived from the price of the underlying asset. In an options contract, the seller must buy or sell the underlying asset to the buyer at an agreed price on a specified date. Buyers are under no obligation to purchase the underlying assets but may exercise their rights if they choose to do so. If an option is about to expire and the underlying asset moves not favorably enough to make exercising the option worthwhile, the buyer can let the option expire and lose the amount they paid for the option.

Futures are obligations to buyers and sellers. The seller of a futures agrees to deliver the underlying asset at expiration, and the buyer of the contract agrees to purchase the underlying asset at expiration. The price they receive and pay respectively is the price at which they entered the futures contract. Most futures traders close their positions before expiration because there is little need for retail traders and hedge funds to actually own, say, a barrel of oil. However, they can buy or sell a contract at a price, and if the price moves in their favour, they can exit the trade and make a profit. Futures are a type of derivative because, for example, the price of an oil futures contract is based on changes in the price of oil.

Main gains

• The underlying asset represents the asset from which the derivative derives its value.
• Understanding the value of the underlying asset helps traders determine the appropriate action (buy, sell or hold) to take on their derivatives.

Example of underlying asset

In the case of stock options, the underlying asset is the stock itself. For example, a stock option to purchase 100 shares of Company X stock at a price of $100, and the underlying asset is the stock of Company X. The underlying asset is used to determine the value of the option before it expires. The value of the underlying asset may change before the contract expires, affecting the value of the option. The value of the underlying asset at any given time lets traders know whether an option is worth exercising.

The underlying asset can also be a currency or market index, such as the S&P 500. In the case of a stock index, the underlying asset consists of the common stocks in the stock market index.

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