# Underlying Security

## What Is Underlying Security?

An underlying security is a stock or bond on which derivative instruments, for example, futures, ETFs, and options, are based. It is the primary part of how the derivative gets its value.

## Figuring out Underlying Security

In derivative phrasing, the underlying security is frequently alluded to just as "the underlying." An underlying security can be any asset, index, financial instrument, or even another derivative. The notorious collateralized debt obligations (CDOs) and credit default swaps (CDS), which were front and center in the Financial crisis of 2008, are likewise derivatives that rely upon the movement of an underlying.

The job of the underlying security is only to act naturally. In the event that there were no derivatives, traders would just buy and sell the underlying. Notwithstanding, with regards to derivatives, the underlying is the thing which must be delivered by one party in the derivative contract and accepted by the other party. The exception is the point at which the underlying is an index, or the derivative is a swap where just cash is traded toward the finish of the derivative contract.

There are many widely utilized and exotic derivatives, yet they all share one thing practically speaking which is their basis on an underlying security or underlying asset. Price movements in the underlying security will fundamentally influence the pricing of the derivative in light of it.

For instance, a call option on Alphabet, Inc. (GOOGL) stock gives the holder the right, however not the obligation, to purchase Alphabet stock at a price determined in the options contract. In this case, Alphabet stock is the underlying security.

Traders use derivatives to either speculate on, or hedge against, the future price movements of the underlying. The more complex a derivative, the more critical the degree of speculation and hedging. For instance, options on futures are wagers on the future price of the futures contract, which in itself is a wagered on the future price of the underlying.

## Underlying Security Example

Suppose we are keen on buying a call option on Microsoft Corp. (MSFT). Buying a call gives us the right to buy shares of MSFT at a certain price during a certain period of time. Generally talking, the value of the call option will increase alongside an increase in the share price of MSFT. Since the call option is a derivative, its price is tied to the price of MSFT. In this case, MSFT is the underlying security.

The underlying is likewise essential to the pricing of derivatives. The relationship between the underlying and its derivatives isn't linear, despite the fact that it tends to be. Generally talking, for instance, the more far off the strike price for a out-of-the-money option is from the current price of the underlying, the less the option price changes per unit of movement in the underlying.

Likewise, the derivative contract might be written so that its price might be straightforwardly associated, or [inversely correlated](/reverse connection), to the price of the underlying security. A call option is straightforwardly connected. A put option is conversely connected.

## Features

- An underlying security is a stock or bond on which derivative instruments, like futures, ETFs, and options, are based.
- Traders use derivatives to either hypothesize on, or hedge against, the future price movements of the underlying security.
- Much of the time, the underlying security is the thing which must be delivered by one party in the derivative contract and accepted by the other party.