Also known simply as the underlying, an underlying security is an asset of some type that serves as the basis for some sort of investment activity, such as an options contract. The type of asset involved can vary, based on the nature of the investment. Assets such as indices, shares of stock, bonds, or just about any type of financial instrument with a verifiable market value may be utilized as the underlying security.
The purpose of the underlying security is to provide support for the option contract that has been arranged between the buyer and the seller. For example, in an options contract that provides the buyer with the option to purchase a certain number of shares of stock at a fixed price by a certain date, those shares of stock serve as the underlying for that contract. With this arrangement, the buyer can either choose to exercise this option to buy before the expiration date of the contract, or allow the contract to expire if he or she decides that the shares have not performed as anticipated.
Understanding the nature of the underlying security in any type of investment situation is extremely important. Since the value of that asset will have a direct impact on the potential returns that the buyer can earn from the investment, taking some time to look into the past performance of that asset will yield valuable clues that can be used to project how the asset will perform over the life of the options contract. An investor can use this history to get an idea of how the asset has appreciated or depreciated in certain economic circumstances and relate that information to what is likely to occur in the marketplace over the next several months. This will make it easier to decide if the possible returns from entering into the contract is worth the risk.
When the underlying security is a bond issue, there is usually a lower amount of volatility involved. This does not mean the investor should not still consider the financial stability of the bond and the institution that issued that bond. While considered a safe investment, there are instances in which a bond may go into default or even be called early. By making sure the underlying security is sound and has a good chance of remaining in place all the way to maturity, the investor stands to enjoy greater benefits from the contract.