What is an Underlying Asset? | Definition and Example


An underlying asset is a financial instrument on which a derivative contract is based. It serves as the basis for different financial products, such as options, futures and swaps. The value of the derivative is derived mainly from the performance of this underlying asset, which can include commodities, stocks, bonds, currencies or indices.

Underlying Asset in a nutshell

  • The underlying asset is the foundation of derivative contracts like options and futures.
  • Bonds, stocks, commodities, market indices, and currencies are examples of underlying assets.
  • Derivatives are traded on futures markets, while underlying assets are exchanged on cash markets.

Understanding Underlying Asset

The asset on which financial instruments, such as derivatives, are based is referred to as the underlying asset, and its value is directly or indirectly linked to the contracts of the derivatives. The derivatives produced from them are always traded on the futures markets, whereas they are always exchanged on the cash markets.

A Derivative is a financial instrument derived from another financial asset.

  • The tangible financial belongings or security based on financial derivatives are the underlying asset in the investment realm.
  • Some underlying assets are Interest rates, bonds, stocks, commodities, market indices, and currencies.
  • Different underlying asset classes and financial derivatives are exposed to various types of investment risk.

The underlying assets influencing the development of several financial derivatives include bonds, stocks, interest rates, commodities including gold, and currencies. Forward contracts, and collateralized debt obligations (CDOs), credit default swaps (CDS) are some of the most well-known financial derivatives, along with options (CDOs).

Types

Stocks

Stock options are among the most well-known and frequently traded financial derivative products. Derivatives like stock options have a value dependent on the underlying asset, the real stock. For instance, a call option on a stock gives the buyer the ability to buy the stock at a specific price (the option’s strike price) until the option expires.

Debt Securities or Bonds 

A bond is a financial instrument that provides the holder with set interest payments. Bonds are issued by businesses and government entities to raise money for funding commercial and government projects. Such instruments’ owners are referred to as creditors of debt.

Examples

Here are a few examples to help you understand:

  • Consider an underlying asset with a downward risk, such as stocks A bought for $100.
  • The holder holds 2 shares of stock A. The holder has the chance to purchase a put option on Stock A with a $100 strike price that is now trading at $10.
  • A put option, a derivative contract, offers the right to sell the underlying asset at a defined strike price before the expiration date.
  • The put option grants the right to sell, but there is no duty.
  • The stock A, from which the put option was developed and formed, serves as the underlying asset in this situation.

What are Underlying Assets for Binary Options?

Underlying assets in binary options are valuable holdings on which the entire trade is based. As a trader, you need to analyze the fluctuating asset value and place your bet accordingly. If you have correctly predicted the price of an asset, you will make a profit. Otherwise, you will lose the trading amount. 

Financial news, like reports of companies and market changes, generally swings the value of an asset in a given time. 

Popular Underlying Assets for Binary Trading

Every binary options broker does not offer similar assets. However, the assets mentioned below are the popular ones in options trading. 

Forex

Currency pairs like USD/EUR, USD/JPY, EUR/GBP, and USD/GBP are commonly traded in binary options. This is because to trade in currency; you need to speculate whether the price of one currency will be more than the other one or not. 

Stocks 

With binary options, you can trade on the stocks of different companies like Apple, Coca-Cola, Google, and more. You can also invest in local stocks depending on the broker you are trading with. 

Commodities 

You can enter the binary options trading world by investing in commodities like silver, oil, or gold. Commodity trading is a low-risk investing method and can diversify the overall risk. 

Indices 

With indices, you can invest in larger markets like DAX, FTSE, and S&P. By investing in indices, you can diversify the risk and make more profit.

Understanding Gold as an Underlying Asset

Gold is a commodity that is a highly well-liked instrument that can be used for investing as well as security purposes. Gold may be used to stop growing inflation rates, stopping any possible decline in the value of US dollars.

  • The dollar carries the distinction of being a widely recognized form of money.
  • Gold is an underlying asset that never loses its value.
  • Gold can be a backup investment when the dollar value declines due to growing inflation.
  • Mechanism to prevent value loss, control inflation, and lessen the possible effects of a currency collapse.

Financial derivatives are often used in investing as risk management tools. For instance, a stockholder who owns many instruments of a certain commodity may use derivative options on the stock to protect his investment in the underlying asset.

About the author

Percival Knight
Percival Knight is an experienced Binary Options trader for more than ten years. Mainly, he trades 60-second trades at a very high hit rate. My favorite strategies is by using candlesticks and fake-breakouts

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