What is an underlying asset?
In derivatives trading, an underlying asset is the financial instrument represented by a derivative, and is what gives a derivative its value.
An underlying asset often takes the form of a stock or a commodity, but it can be any asset that provides value.
Where have you heard about underlying assets?
You may not have heard much about underlying assets as a general concept, but you will have heard about underlying assets in their individual states. Stocks, commodities, futures and even currencies, are some of the most common forms of underlying assets today.
What you need to know about underlying assets...
One example of an underlying asset is when buying or selling a stock option.
Say an option allows a trader the right to buy stock in X. Within that option, the underlying asset is the stock itself, as it's this financial instrument that gives the option its value. Without the underlying asset, the derivative has no intrinsic value.
A second example is in futures trading. A futures trader will buy or sell a contract that promises to deliver an underlying asset on a set future date.
In a contract for difference (CFD) trade, the profit or loss depends on the price movement of the underlying asset in relation to the position taken, although the underlying asset is never actually bought or sold.
Over time, the value of an underlying asset could increase or decrease, which in turn changes the value of its option. Whether or not a derivative is a good investment comes down to the potential change of value of the underlying asset behind it.