In financial circles, assets make the world go round. The goal is to accumulate the most valuable assets to create and sustain long-term wealth.
That lifelong process starts with education, and that, in turn, begins with a key tenet of wealth building: knowing all about underlying assets and what role they play in portfolio management.
What is an Underlying Asset?
An underlying asset is the foundational security, or investment vehicle, on which derivatives operate. Underlying assets can be individual securities (like stocks or bonds) or groups of securities (like in an index fund).
A derivative represents a financial contract between two or more parties based on the current or future value of an underlying asset. Derivatives can take many forms, with trading in widely used markets like futures, equity options, swaps, and warrants. These are high-risk, high-reward vehicles where investors bet on the future value of an underlying asset, and they are often used as hedges against other investments (which seeks to reduce investment risk) or as speculative instruments that pay off down the road (which can heighten investment risk.)
That’s where underlying assets come into play. To make the most optimal derivative bets, investors aim to either hedge risk or enhance it, by making speculative moves in higher-risk areas like options and futures. The underlying assets that enable those bets are critical to the derivatives investment process.
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How Underlying Assets Work
To illustrate how underlying assets work in the derivatives market, let’s use options trading as an example.
An option is a financial derivative that gives the contract owner the right to buy or sell an underlying security at a specific time and at a specific price. When an option is exercised by the contract holder, that simply means the holder has exercised the rights to buy or sell an underlying asset and now owns (or sells out of) the underlying asset.
Options come in two specific categories: puts and calls.
• Put options allow the options owner to sell an underlying asset (like a stock or commodity) at a certain price and by a certain date (known as the expiration date.)
• Call options enable the owner to buy an underlying asset (like a stock or a commodity) at a certain price and at a certain date.
The underlying asset comes into play when that options contract is initiated.
Example of an Underlying Asset in Play
Let’s say for example that an investor opts to buy Microsoft (MSFT) at an options strike price (the price you can buy the shares) of $275 per share. The stock is currently trading at $325 per share. The contract is struck on September 1 and the options contract expiration date is November 30.
Now that the contract is up and running, the performance of the underlying asset (Microsoft stock) will define the success or failure of the options investment.
In this scenario, the options owner now has the “option” (hence the name) to buy 100 shares of Microsoft at $275 per share on or before November 30. If the underlying stock, which is now trading at $300, remains above the $275 strike price, the options owner can exercise the contract and make a profit on the investment.
If, for example, MSFT slides to $280 per share in the options contract timeframe, the call options owner can exercise the purchase of Microsoft at $275 per share, $5 below the current value of the stock (i.e., the underlying asset.) With each contract representing 100 shares of stock, the profits can add up on the call option investment.
If on the other hand, Microsoft stock falls below the $275 per share level, and the November 30 deadline has come and gone, the options owner loses money, as the underlying asset is valued at less than $275, although that’s the price the options owner has to pay for the stock by the expiration date.
That scenario represents the power of the underlying asset. The derivatives investment depends entirely on the performance of the underlying asset, with abundant risk for derivative speculators who’ve bet on the underlying asset moving in a certain direction over a certain period of time.
5 Different Types of Underlying Assets
Underlying assets come in myriad forms in the derivatives trading market, with certain assets being more equal than others.
Here’s a snapshot.
1. Stocks
One of the most widely used underlying assets are stocks, which is only natural given the pervasiveness of stocks in the investment world.
Derivatives traders rely on common and preferred stocks as benchmark assets when making market moves. Since stocks are so widely traded, it gives derivatives investors more options to speculate, hedge, and generally leverage stocks as an underlying asset.
2. Bonds and Fixed Income Instruments
Bonds, typified by Treasury, municipal, and corporate bonds among others, are also used as derivative instruments. Since bond prices do fluctuate on general economic and market conditions, derivative investors may try to leverage bonds as an underlying asset as both bond interest rates and price fluctuate.
3. Index Funds
Derivative traders also use funds as underlying assets, especially exchange-traded funds (ETFs), which are widely traded in intra-day trading sessions. Besides being highly liquid and fairly easy to trade, exchange-traded funds are tradeable on major global exchanges at any point during the trading day.
That’s not the case with mutual funds, which can only be traded after the day’s trading session comes to a close. The distinction is important to derivative traders, who have more opportunities for market movement with ETFs than they might with mutual funds.
ETFs also cover a wide variety of investment market sectors, like stocks, bonds, commodities, international and emerging markets, and business sector funds (such as manufacturing, health care, finance, and more recently, cryptocurrencies). That availability gives derivatives investors even more flexibility, which is a characteristic investors typically seek with underlying assets.
4. Currencies
Global currencies like the dollar or yen, among many others, are also frequently deployed by derivative investors as underlying assets. A primary reason is the typically fast-moving foreign currency (FX) market, where prices can change rapidly based on geopolitical, economic, and market conditions.
Currencies usually trade fast and often, which may make for a volatile market — and derivative investors tend to steer cash toward underlying assets that demonstrate volatility, as quick market movements allow for quick money-making opportunities. Given that they move so quickly, currencies can also move in the wrong direction quickly, which is why investment experts generally advise individual investors to shy away from markets where investment risk is abundant.
5. Commodities
Common global commodities like gold, silver, platinum, and oil and gas, are also underlying assets that are widely used by derivatives investors.
Historically, commodities are one of the most volatile and fast-moving investment markets. Like currencies, commodities are often highly desirable for derivative traders, but high volatility may lead to significant investment losses in the derivatives market if the investor lacks the experience and acumen needed to trade against underlying assets.
The Takeaway
Underlying assets used in derivative deals can come with high risk — and trading against those assets require a comprehensive knowledge of trading, leverage, hedging and speculation.
Those attributes are typically aligned with high-end investment firms, hedge firms, and other institutional investors. They’re not typically associated with regular people looking to save for retirement and build household wealth. Regular investors will likely be looking to balance risk and return to help save for the future.
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