What do underlying assets have to do with derivatives and trading?

Derivatives and underlying assets

In trading and investments, there is a term called derivative. It is a financial security, and its value depends on a single underlying asset or a group of assets as a basis. Derivatives are contracts between two entities. The price depends on how the underlying asset behaves. Examples of derivatives include stocks, currencies, bonds, commodities, interest rates, market indices, and the like. We can usually buy them from brokers and brokerage firms.

So, what are underlying assets?

We defined derivatives first to have a further view of what underlying assets are. Underlying assets play a significant role in derivatives and their values. For instance, if you own an option on Company A’s stock, you can either buy or sell Company A at the strike price until the expiration date. Company A’s stock is the underlying asset for the option in this scenario. We see that underlying assets help determine the item inside the agreement, which gives the contract a value. The entities involved in the derivative contract can come up with rules or agreements. Hence, this fact can add more reassurance to both parties.

Tell me more about it.

Let us assume that you are interested in options or futures contracts. The price will now be derived from the price of the underlying asset. Thus, we call them derivatives.

Let us say that you went with an option contract. The writer is supposed to buy or sell the underlying asset to the buyer on a chosen date at a price you both agreed upon. On the other hand, the buyer does not have to buy the underlying asset but has the right to if he wants to. If you are thinking about why there is a rule like this, it’s because sometimes, these options have underlying assets that may not move in your favored direction. Hence, it’s not worth it to go through with them. So, the buyer can let it expire. But here’s the thing, the buyer will lose the money they paid for that option.

What about for futures? In futures, the buyer and seller both have obligations. The seller must provide the underlying asset at the expiry date, and the buyer must buy that underlying asset on the date of expiry. Both of them already entered a price to give and receive beforehand. It’s not uncommon for traders who prefer to trade futures to close their position before the expiration date comes—people who trade futures with commodities as underlying assets do not need to have the items physically. For instance, traders will not want to own barrels and barrels of oil or kilos and kilos of coffee unless the trader is also building a coffee shop. Here is what they do sometimes: buy and sell the contract at one price. If everything goes well, they can exit with their profits.

A quick summary to end today’s lesson

We now know that underlying assets are like representatives for assets that give derivatives their value. It’s essential to know the underlying asset’s value for traders to know their next course of trading action. And when we say this, we mean the decision to buy, hold, or sell the derivative they own.