when an asset is used as the underlying of a derivative or futures contract this has the advantage of providing additional liquidity and volume to the market for that asset that might not have been available in the spot market 
for example when a trader buys or sells an options contract they are trading an obligation to buy or sell the underlying security if the option is exercised someone will have to buy that security thereby increasing the liquidity of the market the main disadvantage is the danger that underlying assets could be adversely affected by speculation in the derivatives markets during the 2007 housing crisis real estate prices soared due in part to speculative trading in mortgage backed securities and highly complicated derivatives contracts when the derivative bubbles collapsed prices of the underlying assets crashed as well derivatives trading provides additional liquidity and volume to underlying spot marketsunderlying assets benefit from having a well organized and structured trading market underlying assets tend to be less volatile than their derivatives speculative behavior can adversely affect underlying assets each underlying asset has its own risk profile that can affect its derivatives types of underlyingsunderlyings can vary in many different ways based on the derivative contract some of the more common here are the main types of underlyings limitations of underlyingsthe concept of a derivative market would not be able to exist without underlying however there are some constraints regarding the execution of derivative contracts for instance the fact that a security may be illiquid may simply change the value of the derivative contract though that may not necessarily be the point of the contract in certain markets participants may actually be able to manipulate the underlying asset there may be some logistical challenges with underlyings for commodity underlyings physical storage and delivery present practical challenges for other forms of physical underlying it may be challenging to store insure protect and ensure the asset does not go obsolete or stolen as the derivative contract runs its course on the other hand technological risks are pertinent for digital and cryptocurrency underlying despite even the most robust cybersecurity efforts hacking fraud and technical failures can severely impact asset values or cause underlying assets to be lost there may be many efficiencies to trading digital underlying but electronic assets present themselves unique challenges as well example of underlyingtwo of the most common types of derivatives are referred to as calls and puts a call derivative contract gives the owner the right but not the obligation to buy a particular stock or asset at a given strike price if company a is trading at 5 and the strike price is hit at 3 the price of the stock is trending up the call is theoretically worth 2 in this case the underlying is the stock priced at 5 and the derivative is the call priced at 2 a put derivative contract gives the owner the right but not the obligation to sell a particular stock at a given strike price if company a is trading at 5 and the strike price is hit at 7 the price of the stock is trending down the put is trading 2 in the money and is theoretically worth 2 in this case the underlying is the stock priced at 5 and the derivative is the put contract priced at 2 both the call and the put are dependent on price movements in the underlying asset which in this case is the stock price of company a 