What is
an Underlying Asset?

How can we define an underlying asset as an investment term? This is a name that is typically used to explain what type of financial asset is based upon. For example, an investment such as a derivative. It is this underlying instrument that the price is based on, so its performance will determine whether the investment makes a profit or not.

What is an underlying asset if you have an option on a certain stock, to buy or sell it at a certain price up to a fixed date? In this case, the underlying asset is the stock in question. Your decisions will be based on whether its price rises or falls in the way you expected it to.

Of course, you may decide to buy the underlying asset directly, by buying a certain number of shares in a company, for example. This lets you benefit directly from any price increase. However, the idea of using an instrument that covers various assets can increase your portfolio diversification and can also be used with trading strategies such as hedging.

Derivative Contracts and Underlying Assets

Having looked at the underlying asset meaning, we now need to understand what is a derivative, and how underlying assets relate to them. Derivative trading is when a trader speculates on the future price of an asset rather than buying it. The types of underlying assets in derivatives include the likes of a stock, currency, or commodity.

The underlying asset is crucial, as any movement in its price will determine whether you make a profit. You need to understand the current price and what you expect to happen next, to know what action to take at each stage.

What does derivative mean in hedging terms? The derivative meaning is also useful in understanding how traders use this type of instrument to hedge against falling prices. If they already hold the underlying asset, carrying out derivative trading on it can give them a degree of protection against the risk of the price falling.

Derivatives are regarded as being more sophisticated investment vehicles, as they require a higher level of market knowledge than the straightforward purchase of assets. Yet, some of the most common investment vehicles now make it easier than ever before for inexperienced investors to choose this way of investing. Naturally, it is important to understand what this kind of investment is about and what underlying assets it is based on.

Types of Underlying Assets

As we have seen, there are several possible underlying asset types. These are typically the same types of assets that you could buy on the market directly if you chose to do so.

By looking at each one in turn in the following list of underlying assets, you can get a better feel for how they are used. The reason for choosing a derivative varies in each case, as they function differently and offer various opportunities.

Stocks

A stock gives the holder the ownership of a small percentage of a company. When they are the underlying asset within a financial derivative, this produces market risk for the trader, as the share price may vary from what was expected, due to market conditions and the general economy. Investing in a vehicle with a range of stocks as an underlying asset can give a lower risk level when compared to buying a single stock.

Debt securities or bonds

Bonds can be used in call options or put options, meaning that they give the trader the right to either buy or sell the bond, which is the underlying instrument. They are also easily available as derivatives and are most commonly seen as parts of bond ETFs, which we will look at in the next point.

With debt securities, the risk of default is one of the main concerns, but bonds are regarded as among the lower-risk investments, provided that they come from a highly-rated issuer like the stable government of a major country.

ETFs

Exchange-traded funds (ETFs) hold a variety of underlying assets in them, to give a diverse type of investment vehicle in a simple to understand package. They are sold on the stock exchange and cover just about any type of instrument, such as stocks in a certain sector, commodities or bonds. They provide a relatively easy way for new investors to get started on a varied portfolio where the risk depends upon the mix of underlying assets used.

Market index

With the example of a market index such as the Dow Jones or NASDAQ, the underlying assets are the stocks that are included in it. You can diversify and lower risk by investing in an index through a fund that tracks it. With many market indices to choose from, this is an approach that lets you focus on a broad sector very easily.

Currency

The use of a fiat currency or crypto as an underlying asset is also achieved through instruments such as ETFs and diversified funds. With crypto, this can be a way of lowering the risk of volatility in specific tokens, although there is also the risk of changes that affect the whole market. On the other hand, you can look to benefit if you think that crypto-assets will increase in value but aren’t sure of the exact tokens to invest in.

Commodities

Commodities such as gold, oil, and coffee can also be used as underlying assets in vehicles like ETFs, index-tracking funds, and options. These methods all provide different ways of diversifying a portfolio, as commodities tend to react differently to stocks and currencies when the overall market conditions vary.

Examples of Underlying Assets

We can see an example of how you can invest in the stock market through an ETF without buying the underlying asset. The idea is that you find an ETF that reflects the area of the stock market you are interested in, but you don’t need to carry out all of the research, as well as the buying and selling of individual stocks.

If you are interested in commodities trading, this can be done in a number of ways. For example, you could look at funds that track certain commodities. Another popular method involves crude oil options and other energy derivatives. With other types of underlying instruments, there are similar options that let you choose the way of investing that suits you.

How can you get started on choosing the right underlying investment and the correct way of investing in it? Identifying the area you most want to invest in is a good idea to get you started. Let’s say that you believe that cryptos offer the potential for high returns.

You can then look at the positives and negatives of this kind of investment. In the case of crypto, it may be the expected high level of volatility and the difficulty in knowing which token will gain the most value. With this in mind, you can then look at the different ways of investing in this underlying asset using ETFs, options etc, to see which way may help to remove any negatives.

Underlying Assets on eToro

Some positions on eToro involve ownership of the underlying assets, such as long (BUY), non-leveraged positions on stocks and cryptos. Others employ CFDs, which enable a variety of options, such as leveraged trades, short (SELL) positions, fractional ownership and more.

A look at the markets you can trade in with eToro reveals a variety of different ways of doing this. This list of ETFs from eToro includes funds that cover different market sectors and regions, giving you the flexibility to look for something that meets your current needs. Alternatively, you could buy the underlying assets by purchasing specific shares.

With commodities, a good example is how the SPDR Gold ETF (GLD) is based on the underlying value of the precious metal. Again, you have the option of investing directly in a commodity too if you prefer.

On eToro, you will find a range of indices from the AUS200 to the UK100. You could look through to try and find one that covers the area you think offers the most value for investing in right now.

In this way, with eToro you are buying the underlying asset or investing in its future movements, depending upon your preference and outlook. Alternatively, now you fully understand the underlying asset meaning, you may decide to use the CopyTrader function to copy top traders who invest in the area that most interests you.

Summary

By looking at the underlying asset meaning, we have gone over the following areas that every investor needs to understand:

• You can buy the underlying asset or invest in its price movements without actually owning it.
• All of the major markets and types of assets offer different ways of trading, with ETFs, index funds and options among the most common.
• There are both advantages and disadvantages to buying the underlying asset.
• A diversified portfolio may contain a variety of underlying assets in various types of investment vehicles.