UNDERLYING ASSETS:
BEDROCK OF INVESTING

This article explores the role underlying assets play in investment strategies and decisions.

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Underlying assets are the cornerstones of investment products. Their price movements plot the rise and fall of things such as derivatives, ETFs, and options. Understanding what they are and the role they play in investment strategies support informed investment decisions.

What are underlying assets?

Underlying assets are financial instruments that form the foundation and determine the value of financial products. Upward or downward shifts in the value of an underlying asset affect the gains or losses of investment or financial products based on that asset.

For instance, if you hold an option to buy Apple shares at a specific price, Apple stock is your underlying asset, and its price movements directly influence your option’s worth. Another example is a call option on BP shares. Here, BP stock serves as the underlying asset. If BP’s share price rises above your option’s strike price, you could potentially profit by exercising your right to buy at the lower predetermined price.

“The key to successful derivative trading lies not in complex strategies, but in thoroughly understanding the underlying asset’s behaviour and market dynamics.”

John Murphy, Technical Analysis Expert

How do underlying assets work?

Investing in underlying assets is an indirect investment strategy with lower capital requirements and the potential for growth in both rising and falling markets. As an indirect approach, investors do not directly own underlying assets, but experience gains or losses in tandem with the ebb and flow of the values of these.

Underlying assets are the physical things underpinning and driving investments. Essentially, you invest in the future value of an underlying asset as opposed to a financial product. The latter is a vessel for an underlying asset. That means the values of underlying assets directly affect the values of specific financial products.

The performance of your investment hinges entirely on what happens to the underlying asset’s value. If it rises, the investment rises; if it falls, the investment falls. This relationship remains constant, regardless of whether you trade CFDs, options, or futures.

What is the connection between underlying assets and derivatives?

The connection between derivatives and their underlying assets forms the cornerstone of modern financial markets. Thus, derivatives are financial instruments whose value depends on the price of another asset—the underlying asset. This relationship allows investors to gain exposure to various markets without the complexities of direct ownership.

When you trade derivatives, you enter into a contract based on the underlying asset’s future price movements. The derivative’s value fluctuates in response to changes in the underlying asset’s price, though the relationship is not always one-to-one. Factors like time decay, volatility, and market sentiment can influence derivative prices independently of the underlying asset’s spot price.

For example, a futures contract on gold derives its value from the expected future price of gold. As market expectations shift, so does the futures price. It creates opportunities to invest in assets without physically possessing or handling them.

Common uses of derivatives in investing and trading

Derivatives serve multiple purposes in investment portfolios. Hedging stands out as a primary application, where investors use derivatives to protect existing positions against adverse price movements. If you own £10,000 worth of FTSE 100 shares, you might purchase put options as insurance against a market downturn.

Speculation represents another common use, allowing traders to amplify their market exposure through leverage. This approach can magnify both gains and losses, making it suitable primarily for experienced investors who understand the risks involved.

What are the different types of underlying assets?

There is a diverse range of underlying assets, such as stocks, bonds, ETFs, and so on, each with unique characteristics and risk profiles. Understanding the different types helps you choose investments aligned with your goals and risk tolerance.

Stocks and shares

Equities are the most popular underlying assets for retail investors. As underlying assets, stocks provide access and exposure to individual companies’ performance. Options on shares like Amazon or Tesla allow investors to benefit from price movements without committing the full capital required for direct ownership.

Stock derivatives also enable strategies that are not possible with direct share ownership. such as short selling.

Bonds and debt securities

Government and corporate bonds function as underlying assets for various derivative products. Bond derivatives help investors manage interest rate risk and credit exposure. For instance, UK gilt futures allow traders to speculate on or hedge against changes in government bond prices, which typically move inversely to interest rates.

ETFs

Exchange-traded funds serve dual roles. They can be underlying assets themselves while simultaneously holding baskets of other underlying assets. For instance, an ETF tracking the FTSE 100 contains all the index constituents as its underlying assets. When you trade options on this ETF, the fund itself becomes your underlying asset, providing diversified exposure through a single instrument.

Market indices

Indices like the S&P 500 or DAX represent weighted baskets of stocks, which serve as underlying assets for numerous derivative products. Index derivatives offer broad market exposure without requiring investors to purchase individual components. This approach suits those seeking diversified exposure to entire markets or sectors rather than specific companies.

Currencies

Foreign exchange serves as the underlying asset for forex derivatives, including currency futures and options. These instruments help businesses hedge currency risks and enable traders to speculate on exchange rate movements. The GBP/USD pair, for instance, underlies various derivative contracts that track the pound’s value against the dollar.

Commodities

Physical commodities—from precious metals to agricultural products—underpin a vast derivatives market. Commodity derivatives allow market participation without the logistics of physical ownership. Gold futures, crude oil options, and wheat forwards all derive their value from the respective spot prices of the physical commodities.

Examples of underlying assets in practice

Let’s explore how underlying assets function in real investment scenarios to solidify your understanding.

Underlying assets in real-world applications

Consider a UK investor interested in profiting from rising oil prices without storing physical barrels. They might purchase a Brent crude futures contract. Here, Brent crude oil is the underlying asset, and the contract’s value fluctuates with oil price changes. If oil rises from $80 to $90 per barrel, the futures contract gains value accordingly.

Another example involves currency hedging for international businesses. A British company expecting payment of €1 million in three months might buy a currency option with EUR/GBP as the underlying asset. This protects against the pound strengthening against the euro, which would reduce the sterling value of their euro receivables.

Underlying assets in investment strategies

Different underlying assets suit various investment strategies. Growth investors often focus on stock derivatives, using options to gain leveraged exposure to high-growth companies. Meanwhile, income-focused investors might prefer bond ETFs as underlying assets, benefiting from regular distributions while maintaining liquidity.

Portfolio diversification becomes more accessible through derivatives on different underlying assets. For example, by combining equity options, commodity futures, and currency forwards, investors can build robust portfolios resistant to single-market dips.

Underlying assets on eToro

eToro provides access to various underlying assets through multiple investment vehicles, catering to different experience levels and investment objectives.

Available options

On eToro’s platform, there are several ways to gain exposure to underlying assets. Direct ownership involves buying actual stocks or cryptocurrencies, where you own the underlying asset itself. This approach suits long-term investors seeking dividend income or voting rights. For stocks and cryptocurrencies, non-leveraged long positions mean you own the actual underlying asset.

Alternatively, eToro offers CFD trading for various underlying assets. CFDs enable leveraged trading, short positions, and fractional ownership—features unavailable with direct asset ownership. This flexibility appeals to active traders seeking to profit from short-term price movements in either direction.

Direct vs indirect investments

The choice between direct and indirect investments depends on your objectives. Direct ownership of underlying assets provides straightforward exposure—if Apple shares rise 10%, your holding gains 10% too. You’ll receive dividends and can hold the assets indefinitely without ongoing costs beyond the initial purchase.

Indirect investment through derivatives offers different advantages. You can gain exposure to expensive underlying assets with less capital output and implement sophisticated strategies. However, these benefits come with increased complexity and risk, particularly when using leverage.

eToro’s CopyTrader feature presents another approach, allowing you to replicate successful traders’ strategies across various underlying assets. This method combines professional insight with your chosen underlying asset exposure, suitable for those learning the markets.

Final thoughts

Investing in derivatives can offer an alternative to buying the underlying asset directly, allowing traders to gain exposure to price movements, take short positions, or use leverage. This flexibility can broaden the range of markets and strategies available to investors.

However, derivatives are complex instruments whose value depends on the performance of their underlying asset, and they can involve significant risks as well as potential rewards. Before trading, it’s important to understand how each product works, consider diversification, and stay informed about market developments.

To learn more about underlying assets, visit the eToro Academy.

FAQs

What’s the difference between owning an underlying asset and trading derivatives on it?

Owning an underlying asset means you directly purchase and hold the actual security, commodity, or currency. Trading derivatives means you’re trading contracts with values depending on the underlying asset’s price movements without owning the asset itself. In both cases, it is important to understand asset classes.

Can underlying assets change over time?

The underlying asset of a specific derivative contract remains fixed throughout its lifetime, for example, fixed income investments tied up in ETFs or bonds However, index compositions can change through rebalancing, affecting index-based derivatives.

Are underlying assets always physical items?

No, underlying assets can be intangible. While commodities are physical, stocks represent company ownership, indices are mathematical calculations, and cryptoassets exist digitally.