What is an underlying asset and how is it traded?
An underlying asset gives a financial contract its reference value. In this guide, we explain what the term means, how underlying assets work, and why they matter when trading derivatives such as CFDs.
Key takeaways
An underlying asset is:
- A financial security or physical object on which an investment contract is based.
- Used by traders to speculate on price movements without having to physically purchase or store the asset itself.
- Commonly stocks, government bonds, foreign currencies, and physical commodities like gold or oil.
- The reference point for a linked contract, meaning that when its price moves up or down, the contract’s value may change accordingly.
What is an underlying asset?
One way to trade the financial markets is through derivative instruments, such as options, futures, and contracts for difference (CFDs). These are contracts between two parties to exchange the price difference of an asset from the start of the contract to its end.
Traders may use derivatives to speculate on price movements without taking physical ownership of an asset. The contract’s value is still linked to a real financial or physical item. For example, a trader can gain exposure to gold without needing to store physical gold bars.
In simple terms, an underlying asset is the core component of a financial contract – the item the contract is based on.
Underlying assets help give derivatives a clear reference point. They can be used by businesses and investors to hedge risks, manage portfolios, or speculate on future market movements. However, the risks depend on the type of asset, the structure of the contract, and the trader’s use of leverage.
Underlying asset definition
The formal definition of an underlying asset is a financial instrument or commodity upon which a derivative contract is based. Its spot market price directly influences the value and settlement obligations of any derivative linked to it.
Meaning of underlying asset explained
To understand what an underlying asset is, imagine a tech-focused ETF that tracks the Nasdaq 100 index. If the tech companies in the index report higher-than-expected quarterly earnings and their collective values rise, the ETF’s price may rise too. If a regulatory change affects the tech sector and the index falls, the ETF may fall in a similar proportion.
The ETF itself does not make business decisions or manufacture products. Its market price largely reflects how the stocks in the index are performing.
In this example, the tech stocks are the underlying assets, and the ETF is a fund whose value mirrors them. The contract does not move independently; its value generally reflects the real-world assets it's based on.
How does an underlying asset work?
To be considered an underlying asset, the security or commodity typically needs a transparent, widely accepted market price. It's usually traded on a public exchange or active market, so both sides of a contract can see its value.
When two parties enter a derivative trade, they select a specific underlying asset, such as shares of Microsoft. They might agree that if the stock price rises above $400.00 by a set date, one party will pay the other the cash difference.
The contract itself has no independent worth. It holds value because Microsoft is a real company with stock traded on the Nasdaq exchange.
Why are underlying assets important?
Underlying assets help give financial contracts structure and provide a way to assess risk. For traders and investors, the underlying asset influences the risk profile of a position. For example, a derivative contract linked to a government bond will usually have a different risk profile from one linked to a more volatile cryptocurrency.
They can also help analysts assess business exposure. If an airline’s underlying cost driver, crude oil, rises sharply, analysts may estimate the potential impact on future profits.
Businesses can also use underlying assets to manage operational costs. For example, a coffee shop chain might use futures contracts to help fix the price of coffee beans months before harvest. This can support planning, although it does not remove all price or contract-related risks.
Underlying asset example
Imagine a trader named Sarah who thinks gold’s price may rise over the next 24 hours. The current spot price of gold is $2,300.00 per ounce.
Rather than buying and storing physical gold, she logs into a regulated CFD trading app and opens a gold CFD position. Here, gold is the underlying asset. Sarah does not own any physical metal, only a contract tracking gold’s real-time global price.
If gold’s price rises to $2,350.00, Sarah’s CFD position may increase in value by around $50.00 per ounce traded, before costs such as spread or overnight fees. She can close the position to realise this gain. If gold’s price falls, however, the position may lose value. The physical gold remains untouched throughout, but it's the underlying asset that makes the trade possible.
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FAQ
What are the common types of underlying assets?
Do I need to own the underlying asset to trade derivatives?
What are the main risks associated with underlying assets?
The main concern is market risk, which is the possibility that the underlying asset’s price moves against the trade. Some securities also carry liquidity risk, where the underlying asset trades infrequently, making it harder to determine a fair value for settlement. With leveraged products such as CFDs, price movements can have a larger impact on account value, so traders should consider risk-management tools, costs, and the possibility of loss before opening a position.