This page explains the concept of an option's underlying asset (or underlying security or often just underlying – these terms are equivalent). It will explain the relationship between an option and its underlying, introduce common types of underlying assets, and provide examples for each.
Relationship between Option and Its Underlying
Options are derivative securities. A derivative is a financial instrument that is based on (or derived from) some other asset, which is called the underlying asset, as it underlies the derivative contract.
An option is a specific type of derivative which represents a right (but not obligation) to buy (in case of a call option) or sell (a put option) a particular quantity of an asset (the underlying asset) at a specific price (the exercise price or strike price).
Example
For example, the 200-strike call option on the Apple (AAPL) stock represents the right to buy 100 shares of Apple at the fixed price of $200 per share. The Apple stock is the underlying for this particular option.
Note: US exchange traded stock options (options whose underlyings are individual stocks) trade in contracts of fixed sizes. One option contract always represents 100 shares of the underlying stock. Therefore, if a trader wants an option to buy 500 shares of Apple, he needs to buy 5 contracts of Apple options.
How Underlying Price Affects Option Price
The price of an option's underlying security is called the underlying price. For example, Apple share price on the stock market is the underlying price for the 200-strike Apple call option (and all other options whose underlying is the Apple stock).
Underlying price is one of the most important factors which drive option prices.
The 200-strike call option on Apple stock will be worth much more when Apple share price is 230 (because it will enable the option holder to save $30 for every share) than when Apple is only 180 (and there will be no saving).
See detailed explanation of underlying price effects on call and put option prices.
Every Option Has an Underlying
If we think of an option as contract between a potential buyer and seller, the underlying is the thing that is being bought and sold. It is the subject of the option contract.
Every option has an underlying. Without it, the option contract would be meaningless, as it would concern nothing. No one would want to buy an option whose underlying is nothing.
Underlying Is Not Always an Asset
The above said, the underlying does not always need to be an asset. Nowadays, options exist on a wide range of economic variables which are not assets, such as index values, currency exchange rates, interest rates, or even non-financial variables such as weather.
The only condition for a suitable underlying is that it must be precisely specified, in order to avoid the option contract being ambiguous. Such specifications will be illustrated in the examples below.
Common Types of Underlyings
Stock Options
Stocks (or equities) are the best known option underlying assets. The above examples with Apple stock option belong here.
Besides individual stocks, exchange traded funds (ETFs) can also be underlying assets for options. In fact, some ETF options (such as those on SPY, QQQ, or VXX) are among the most liquid among US traded equity options.
Index Options
The underlying for an index option is often a stock index, but generally any other index can be an underlying for an option.
S&P500 options or VIX options are examples of index options.
Indices are technically not assets, so here it is more suitable to talk about underlying index rather than underlying asset.
For the same reason, index options are usually cash settled, as delivering the underlying asset would be very difficult (imagine delivering shares in the 500 stocks from the S&P500 index) or impossible (there is no way to deliver the VIX index).
Currency Options
Currency options (or forex or FX options) are among the most liquid options worldwide, although they are less visible than stock or index options, because most of the trading takes place over the counter, outside public exchanges.
The underlying asset (as well as underlying price) for these options is a currency exchange rate, so we often speak of underlying rate rather than underlying asset or underlying price.
For example, the EUR/USD exchange rate (the price of one euro in dollars) is the underlying rate for an EURUSD option.
Interest Rate Options
Like currencies, fixed income instruments such as bonds and interest rates represent some of the most heavily traded option underlyings, although again less visible to general public due to being mostly over the counter.
Examples of underlyings for exchange traded interest rate options include Eurodollar, the 3-month SOFR, and various maturities of treasury notes and bonds.
Commodity Options
Another large area of options trading is commodities, due to the hedging needs of commodity producers and consumers (and not least, speculators attracted by high volatility).
The underlyings for some commodity options are physical commodities themselves. These options have physical settlement, which means the predetermined amount of the commodity is delivered when a call option holder chooses to exercise. The contract specifications are very strict and detailed, often including physical qualities and particular variations of the commodity, as well as exact place of delivery.
Futures Options
One of the most interesting features of derivatives is that one derivative instrument, which has its own underlying asset, can serve as underlying to another derivative instrument, creating a chain effect.
Futures options work like this. The underlying for a futures option is a futures contract, which is a derivative itself and has its own underlying asset.
For example, the underlying for crude oil options traded on the NYMEX exchange is a particular crude oil futures contract traded on the same exchange. The eventual underlying for that futures contract is physical crude oil.
This is often the case with commodities, where most market participants prefer the convenience of futures and cash settlement to physical delivery of a commodity. That said, futures options exist in virtually all other asset classes, including fixed income, currencies, and equities.