what is underlying security 
an underlying security is a stock or bond on which derivative instruments such as futures etfs and options are based it is the primary component of how the derivative gets its value understanding underlying securityin derivative terminology the underlying security is often referred to simply as the underlying an underlying security can be any asset index financial instrument or even another derivative the infamous collateralized debt obligations cdos and credit default swaps cds which were front and center in the financial crisis of 2008 are also derivatives that depend on the movement of an underlying not all stocks will have underlying option chains the role of the underlying security is merely to be itself if there were no derivatives traders would simply buy and sell the underlying however when it comes to derivatives the underlying is the item that must be delivered by one party in the derivative contract and accepted by the other party the exception is when the underlying is an index or the derivative is a swap where only cash is exchanged at the end of the derivative contract there are many widely used and exotic derivatives but they all have one item in common which is their basis on an underlying security or underlying asset price movements in the underlying security will necessarily affect the pricing of the derivative based upon it for example a call option on alphabet inc googl stock gives the holder the right but not the obligation to purchase alphabet stock at a price specified in the options contract in this case alphabet stock is the underlying security traders use derivatives to either speculate on or hedge against the future price movements of the underlying the more complex a derivative the more significant the degree of speculation and hedging for example options on futures are bets on the future price of the futures contract which in itself is a bet on the future price of the underlying underlying security examplelet s say we are interested in buying a call option on microsoft corp msft buying a call gives us the right to buy shares of msft at a certain price during a certain period of time generally speaking the value of the call option will increase alongside an increase in the share price of msft because the call option is a derivative its price is tied to the price of msft in this case msft is the underlying security the underlying is also crucial to the pricing of derivatives the relationship between the underlying and its derivatives is not linear although it can be generally speaking for example the more distant the strike price for an out of the money option is from the current price of the underlying the less the option price changes per unit of movement in the underlying also the derivative contract may be written so that its price may be directly correlated or inversely correlated to the price of the underlying security a call option is directly correlated a put option is inversely correlated 