An underlying instrument is an asset that gives derivatives their value, and the term is commonly used in derivatives trading. Derivatives contracts are financial instruments with a price that is derived from the underlying instrument they track.
Simply put, an underlying instrument is an asset on which a derivative contract’s price is based. The underlying instrument provides value to the derivative, supports the agreement, and the parties involved agreed to exchange the underlying instrument at the derivative’s maturity date.
Read: What is a Derivative?
Example of an Underlying Instrument
Options and shares can be used to describe what an underlying instrument is. Let’s say you buy a put option on stock ABC, which gives you the right – but not the obligation – to sell the stock ABC at the strike price up until the option’s expiration.
In this example, the common stock of ABC is the underlying instrument of the option which gives the contract its value. The option’s price is based on the price of the underlying stock ABC. If the stock’s price changes, the option’s price will also be directly affected, providing investors with the information whether the option is worth executing or not.
The underlying instrument can be any tradable asset class, such as stocks, currencies, commodities, or even real estate. If an investor buys a futures contract on the Canadian dollar to lock the exchange rate at a future date, the Canadian dollar would be the underlying instrument of the futures contract which gives the contract its intrinsic value.
However, unlike option contracts, futures contracts are an obligation for both the buyer and the seller. The buyer of a futures contract agrees to buy the underlying asset at the contract’s expiry, while the seller agrees to provide the underlying asset at expiry. Derivative products and contracts are a significant innovation which has enhanced modern financial markets and shaped them as we know them today.
CFD Derivatives Trading
Derivative contracts which are closer to retail traders are Contracts for Difference or CFDs. These contracts track the market price of securities and derive their value from them. Unlike options and futures contracts, there is no exchange of the underlying instrument and the buyer of the CFD contract doesn’t own the underlying asset physically. The CFD contract only tracks the price of the underlying asset – the buyer makes a profit if the price of the underlying asset rises, or a loss if the price falls.
Still, there are certain benefits of trading on CFDs, such as access to high leverage and the ability to short-sell the contract without notable restrictions. Trading on leverage allows traders to open a much larger position than their initial trading account size would allow.
Basically, the broker provides a loan to the traders and allocates a small amount of the trading account aside as the collateral for the leveraged trade, called the margin. The amount of the margin depends on the leverage ratio utilised by the trader – a 100:1 leverage requires a 1% margin, i.e. 1% of your trading account would be allocated as the margin for the trade. A 20:1 leverage would call for a 5% margin, etc.
Trading on CFDs also allows traders to short-sell the underlying instrument and make a profit from falling prices and bearish markets.
Short-selling refers to borrowing the underlying instrument from the broker and selling it at the current market price in anticipation of lower prices in the future. Once the price falls, the trader would buy the underlying instrument at the lower price and return the borrowed amount to the broker, making a profit on the difference between the selling and buying price.