# What Is Underlying? Definition, Meaning, Pros, Cons, and Example

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## What Is Underlying?

Underlying, when used in equity trading, refers to the asset on which a financial contract is based, such as a common stock delivered when a [warrant](https://www.investopedia.com/terms/w/warrant.asp) is exercised or when a [convertible bond](https://www.investopedia.com/terms/c/convertiblebond.asp) or preferred share is converted to stock. Other examples of underlying assets include commodities and interest rates.

The price of the underlying is the main factor that determines the value of derivatives, warrants, and convertibles, so any change in the underlying's price directly affects the value of the linked derivative.

### Key Takeaways

*   Underlying refers to the security or asset that must be delivered when a contract or warrant is exercised.
*   In derivatives, the underlying is the security or asset that provides cash flow to a derivative.
*   The underlying of a derivative can be an asset, an index, or even another derivative.
*   For convertible securities, the underlying is the stock that can be exchanged for the note.
*   Underlying assets tend to be less volatile than their derivatives.

## How Underlying Assets Influence Markets

Underlying refers to assets in both equities and derivatives. Derivatives contracts are based on the price or value of another asset, like a stock. Here, the stock is the underlying asset. A rise in the stock's price can cause the derivative's market price to change.

In [futures](https://www.investopedia.com/terms/f/futures.asp) contracts, the underlying is a commodity like gold, oil, or wheat. Disruptions in these markets can affect the futures based on them.  

Convertibles are also structured around an underlying asset, sometimes using derivative-like features. These are debts that may be repaid like bonds, or, under certain conditions, may also be repaid in company shares. Since the value of the shares will affect the value of the convertible, the shares are described as the underlying asset to the convertibles.

> **Tip**
>
> While commonly used to refer to assets, an underlying can also be an interest rate, a benchmark, or even another derivative.

## Exploring the Role of Underlyings in Derivatives

"Underlying" is commonly used in derivative contracts structured around another asset. Options are popular derivatives where traders bet on future [stock or commodity](https://www.investopedia.com/ask/answers/06/stockswithoptions.asp) prices. Traders profit if contract terms are met.

An underlying isn't always an asset. Some derivatives have a benchmark index, interest rate, or financial metric as their base. These metrics' rise or fall leads to gains or drops in derivative prices. The underlying could even be another derivative.

Many [interest rate swaps](https://www.investopedia.com/terms/i/interestrateswap.asp) use the [secured overnight financing rate](https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954) (SOFR) to exchange cash flows between two entities. When the SOFR benchmark rate rises, the value of the swap changes as well.

## Advantages and Disadvantages of Using Underlying Assets

Understanding the underlying asset's investment characteristics is crucial in derivatives investing. Each asset's risk profile affects related contracts. Stocks face investment risk, bonds have default risk, and derivatives encounter market risk.

Underlying assets are usually less volatile than their derivatives. A call or put option's value might drop to zero near expiration. In contrast, while stock prices can fluctuate, they rarely lose all their value.

Using an asset as a derivative or a futures contract's underlying enhances its market [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) and [volume](https://www.investopedia.com/terms/v/volume.asp), often more than in the spot market.

For example, when a trader buys or sells an options contract, they are trading an obligation to buy or sell the underlying security. If the option is exercised, someone will have to buy that security, thereby increasing the liquidity of the market.

A key drawback is that speculation in derivatives can harm underlying assets. In the 2007 housing crisis, speculative trading in [mortgage-backed securities](https://www.investopedia.com/terms/m/mbs.asp) and complex [derivatives](https://www.investopedia.com/terms/g/great-recession.asp) caused real estate prices to soar. When these bubbles burst, the underlying asset prices crashed.  

### Pros and Cons of Underlying

Pros

*   Derivatives trading provides additional liquidity and volume to underlying spot markets
    
*   Underlying assets benefit from having a well-organized and structured trading market.
    
*   Underlying assets tend to be less volatile than their derivatives.
    

Cons

*   Speculative behavior can adversely affect underlying assets.
    
*   Each underlying asset has its own risk profile, that can affect its derivatives.
    

## Different Categories of Underlying Assets

Underlyings can vary in many different ways based on the derivative contract. Some of the more common Here are the main types of underlyings:

1.  **Equities:** Underlying assets can be individual stocks or stock indices. For example, in options trading, the underlying asset could be shares of a specific company like Apple (AAPL).
2.  **Commodities:** Commodities such as gold, silver, crude oil, natural gas, agricultural products (wheat, corn, soybeans), and others serve as underlying assets in derivative contracts. These contracts allow investors to speculate on or hedge against price movements in these physical goods, and the rights to commodities can be delivered.
3.  **Currencies:** [Foreign exchange (forex)](https://www.investopedia.com/articles/forex/11/why-trade-forex.asp) markets involve trading currency pairs, with each currency pair representing an underlying asset. For instance, in the EUR/USD currency pair, the euro (EUR) and the US dollar (USD) are the underlying currencies.
4.  **Interest Rates:** Interest rate derivatives are based on interest-bearing assets such as government bonds, treasury bills, and interest rate [benchmarks](https://www.investopedia.com/terms/b/benchmark.asp). The underlying is the actual interest rate itself (for example, in a swap contract).
6.  **Indices:** Indices represent a basket of securities and serve as underlying assets for derivatives. Examples include stock market indices like the Dow Jones Industrial Average or the S&P 500. Instead of just one stock, an underlying could be a basket of them.
7.  **Real Estate:** Real estate assets can serve as underlyings in derivative contracts. Real estate investment trusts (REITs) are also sometimes used as underlying assets in derivatives related to the real estate market as they may be easier to exchange or deliver.
8.  **Cryptocurrencies:** With the emergence of cryptocurrencies like Bitcoin and Ethereum, derivatives tied to these digital assets trade digital currencies. Bitcoin futures and options, for example, are based on the price of Bitcoin as the underlying asset.

## Potential Challenges With Underlying Assets

Derivative markets rely on underlyings, but executing derivative contracts has limitations. Illiquidity can change a derivative's value, though it might not be the contract's aim. In some markets, participants might manipulate the underlying asset.

Underlyings pose logistical challenges. Storing and delivering physical commodities can be tough. Other physical assets may face difficulties in storage, insurance, protection, or preventing obsolescence or theft during a derivative contract's term.

Digital and cryptocurrency underlyings face technological risks. Even strong [cybersecurity](https://www.investopedia.com/terms/c/cybersecurity.asp) can't always prevent hacking, fraud, or technical failures, which might impact asset values or lead to losses. While trading digital assets can be efficient, they have unique challenges.

## Illustrative Examples of Underlying Assets in Action

Calls and puts are common derivative types. A call gives the owner the right, not obligation, to buy stock at a set [strike price](https://www.investopedia.com/terms/s/strikeprice.asp). If company A trades at $5 but the strike price is $3, the call is worth $2. Here, the $5 stock is the underlying, and the call is the $2 derivative.

A put gives the owner the right, not obligation, to sell stock at a strike price. If company A trades at $5 but the strike price is $7, the put is worth $2. Here, the $5 stock is the underlying, and the $2 put is the derivative. Both call and put values depend on company A's stock price changes.

## What Happens When the Price of an Underlying Asset Increases?

Price changes to an underlying asset usually cause price changes to their derivatives as well. For example, a call option represents the right to buy a certain stock for a certain price. If the underlying stock is priced $3 higher than the strike price, the option has a price of around $3. If the underlying falls below the strike price at the time of expiration, the option has a value of $0.

## Is a Share an Underlying Asset?

Shares can be underlying assets, if a derivative is structured around them. Shares are commonly used as the underlying asset for call and put options, which represent sophisticated bets on the future stock price. Shares can also be underlying for convertible debt, which can be converted to shares if certain conditions are met.

## What Are the Primary Underlying Assets?

The most common underlying assets are stocks, commodities, bonds, and currencies. However, there are also derivatives with more abstract underlying values, such as interest and benchmark rates.

## The Bottom Line

Underlyings in financial derivatives are the assets, such as equities, commodities, currencies, interest rates, indices, or real estate, that give derivatives their value. The price of the underlying heavily influences derivative pricing and trading decisions. While derivatives can boost market liquidity and volume, they also carry risks tied to volatility and speculation, which can magnify losses during market swings.