Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
Underlying assets are the financial instruments (stocks, bonds, and commodities) that help determine the value of derivatives (options, futures, and swaps). These assets serve as the foundation for many trading strategies, influencing how derivatives contracts are priced and how risk is managed in the market.
Here, we look at the role of underlying assets in derivatives trading, and outline the five of the most common types used by investors.
Key Points
• Underlying assets are the securities derivatives are based on, such as stocks, bonds, and commodities.
• Investors may trade derivatives to speculate and attempt to profit from the future price movements of underlying assets, or to hedge against risk.
• Derivatives prices are based on the price of the underlying asset, as well as potentially other factors, depending on the type of derivative.
• Derivatives carry high risk and are complex, often requiring advanced trading knowledge.
• These financial instruments may be used by investment firms, hedge funds, institutional investors, and retail investors.
What Is an Underlying Asset?
An underlying asset is a financial instrument, like a stock, bond, or commodity, that helps determine the value of a related derivative contract. Underlying assets can be individual securities (like stocks or bonds) or groups of securities (like in an index fund).
A derivative is a financial contract between two or more parties based on the current or future value of an underlying asset. Derivatives can take many forms, involving trading in widely used markets like futures, equity options, swaps, and warrants, among others.
These contracts can involve significant risk as investors speculate on the future price movements of an underlying asset. An investor may profit if the price of the underlying asset moves as they anticipated, but they could potentially face steep losses if the price moves in an adverse direction. Derivatives are also often used to hedge against potential losses in other investments.
How Underlying Assets Work
To illustrate how underlying assets work in the derivatives market, consider options trading as an example.
An option is a financial derivative that gives the contract holder the right, but not the obligation, to buy or sell an underlying security by or at a specific time and at a specific price. When an option is exercised by the contract holder, that means the holder has exercised the right to buy or sell an underlying asset.
Options come in two specific categories: puts and calls.
• Put options allow the options owner to sell an underlying asset (such as a stock or commodity) at a certain price and on or 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 on or by a certain date.
The underlying asset first comes into play when that options contract is initiated.
Example of an Underlying Asset in Play
Suppose an investor believes the price of a company’s stock is going to rise. The stock is currently trading at $275 per share, and so they opt to purchase a call option with a strike price of $285. 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 (the stock) can determine whether the option becomes profitable or expires worthless.
In this scenario, the options owner now has the “option” (hence the name) to buy 100 shares of the stock at $285 per share on or before November 30. If the underlying stock, which is now trading at $275, moves above the $285 strike price, the options owner can exercise the contract and potentially profit from the difference between the strike price and the market price.
If, for example, the stock slides to $290 per share in the options contract timeframe, the call options owner can exercise the purchase of the stock at $285 per share, $5 below its current value of the stock (i.e., the underlying asset). With each contract typically representing 100 shares of stock, the profits can add up on the call option investment.
If, on the other hand, the stock remains below the $285 per share level, and the November 30 deadline has come and gone, the options owner would not exercise the contract, since the stock is now worth less than the $285 strike price. That’s also the price the options owner has to pay for the stock by the expiration date.
Keep in mind, too, that options buyers must also take into account the amount they spent to purchase the options contract, since this would detract from their potential profits. If for example, the premium for a contract was $1 per share, or $100 total, they would need the price of the underlying asset to rise above $286 (the breakeven point) to profit.
This scenario represents the importance of the underlying asset. The derivatives investment depends entirely on the performance of the underlying asset, with abundant risk for derivative speculators who’ve taken positions 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 used more frequently due to their liquidity and price volatility.
Here’s a snapshot.
1. Stocks
One of the most widely used underlying assets is stocks, which is only natural given the pervasiveness of stocks in the investment world.
Derivatives traders rely on equities 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 based on general economic and market conditions, derivative investors may try to leverage bonds as an underlying asset as both bond interest rates and prices fluctuate.
3. Index Funds
Derivative traders also use funds as underlying assets, especially exchange-traded funds (ETFs), which are widely traded in short-term (or intra-day) trading sessions. Besides being highly liquid and fairly easy to trade, exchange-traded funds are also 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, such as stocks, bonds, commodities, international and emerging markets, and business sector funds (such as manufacturing, health care, and finance). 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 used 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 may create short-term profit potential. Given that they move so quickly, currencies can also move in the wrong direction quickly, which is why some financial professionals caution that currency markets may be too volatile for most individual investors.
5. Commodities
Common global commodities like gold, silver, platinum, and oil and gas can also serve as the basis for derivatives contracts traded by investors.
Historically, commodities have been 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 knowledge required to trade against underlying assets.
The Takeaway
Underlying assets are the fundamental financial instruments used to create derivatives contracts and strategies. Derivatives, such as options, futures, and swaps, can come with high risk — and trading against those assets requires a comprehensive knowledge of trading, position sizing, leverage, hedging, and speculation.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What are underlying assets?
Underlying assets are the foundation of derivatives contracts. They influence how a derivatives contract is priced and serve as the basis of a derivative buyer or seller’s trading strategy. Broadly, investors trade derivatives to try to profit from the future price movements of underlying assets, or to hedge against risk with other assets they own.
What are different types of underlying assets?
The different types of underlying assets may include stocks, bonds, index funds (especially ETFs), global currencies, and commodities like gold and oil. These assets are generally chosen for their liquidity, volatility, and their role as the foundation for various derivatives trading strategies.
Are gold and silver considered underlying assets?
Yes, gold, silver, and other precious metals may serve as underlying assets in derivatives contracts. Precious metals are considered commodities, and derivatives are frequently based on these and other types of commodities, such as oil, gas, and agricultural products. Due to their historical volatility, commodities like gold and silver are often desirable for derivative traders, though these trades entail significant risk.
Photo credit: iStock/MixMedia
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Mutual Funds (MFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN-Q325-032