An underlying security can be a stock, index, bond, interest rate, currency or commodity on which derivatives like futures and options are based. It’s the way the derivative gets its value.
There are many different types of derivatives, but they are all based on an underlying security. Changes in the value of the underlying security affects the pricing of the derivative.
The underlying security can sometimes be referred to simply by the rather coy name “the underlying.”
Traders use derivatives to either predict or protect against changes in the underlying security. The more complicated the derivative, the more speculation as to what it might do. Options on futures are bets on the – you guessed it – future price of the futures contract, which really means it’s a bet on the future price of the underlying.
The only thing an underlying security has to do is be itself. Without derivatives, we’d just buy and sell the underlying. However, when it comes to derivatives, the underlying is the item which must be delivered by one party in the derivative contract and accepted by the other party. The exception is when the underlying is an index, or the derivative is a swap where only cash is exchanged at the end of the contract.
The underlying is understandably a big part of the price of derivatives since they are the underlying value, but the relationship between the underlying and the derivative isn’t always linear. The derivative contract can be directly correlated to the underlying price or inversely correlated. For example, a call option is directly correlated while a put option is inversely correlated.
The underlying reason I want to buy this stock is because of the underlying security that it’s sitting on.