What is an Underlying in Trading?
In trading terms, the underlying refers to the financial instrument, commodity, or asset upon which a derivative's price is based. It's this asset - be it a stock, commodity, bond, or currency - that gives the derivative its value. Simply put, the underlying is the main factor that determines the price of a futures contract, option, or any other type of financial derivative.
Examples of Underlying Assets
When discussing an underlying in the context of trading, it's beneficial to consider some examples. Perhaps the most ubiquitous form is the equity or stock of a company. In this case, a single share of a firm's stock can serve as the underlying for various derivative contracts - like options or futures.
Other examples include commodities like gold or oil, various currencies such as the US Dollar or Euro, or bonds like those issued by governments and corporations. All of these assets can also be the underlying that affects the price of financial derivatives.
Importance of Underlying in Trading
The underlying is crucial in the trading world, primarily because it sets the stage for risk and opportunity. All the price changes of the derivative are directly related to the fluctuations in the price of the underlying asset. Consequently, careful scrutiny of the underlying can form a critical part of a successful trading strategy. The more you understand the underlying, the better positioned you are to predict the movement of the derivative's price.
Underlying Versus Notional Amount
When it comes to derivatives, there is a noteworthy distinction between the underlying and the notional amount. While the underlying is the asset that gives a derivative its value, the notional amount is the unit of this asset indicated in the contract. To put it differently, the underlying is what's being traded, while the notional amount is the quantity.
Conclusion
Understanding the term underlying and its importance can be a key element in the world of trading, especially when dealing with financial derivatives. By knowing what an underlying is, traders can better evaluate risk, plan their strategies, and eventually, optimize their profit potentials. Always remember that the underlying asset is at the core of every derivative contract.
