Options and derivatives
We know that options are classified as derivatives, but do we know why? As the name suggests, it means that their values are derived from an underlying security’s performance or price action. The most significant component where an option gets its value is from underlying option security. Other people consider underlying assets as a similar counterparts. They can be anything from stocks, indexes, currencies, or even commodities — they are the basis of an option’s worth.
An option’s worth
Earlier, we already mentioned a variety of derivatives from where the option may derive from. Yes, they may have different derivatives, but they all have the same common ground. It is the fact that their value depends on an underlying asset or a security. Hence, when an underlying security’s price creates movements, this will create a ripple effect on the option’s pricing. Again, it is because the option’s price or worth is based on that underlying security.
Let us cite an example where a Netflix stock is the underlying stock. Let us assume that I made a call option on the Netflix stock. As a holder, I do not have any obligations, but I do have the right to buy that Netflix stock at a specific price written in the options contract.
Simply, “the underlying”
When we talk about derivatives like options, we often call the underlying asset or underlying security “the underlying.” It can be any derivative such as assets, indexes, financial instruments, and the like. Traders maximize the use options when they make speculations or hedges against the price movements that the underlying option security may have in the future. Traders find combining options help them make a better strategy to meet their specific needs. This also helps them make risk management that personally fits them and their trading style and strategy.
What if there are no options in the world of trading and investments?
Most of the time, this happens when an option is involved: one entity delivers an underlying item in the options contract, and another entity accepts it. We say “most of the time” because there is an exception. In cases where the underlying is an index, the exchange at the end of the options contract is always on a cash basis. So, if options never existed in trading, traders will buy and sell the underlying in a straightforward manner. The underlying does not have any role here other than to be itself.
Other roles of the underlying
It is not a smooth-sailing and linear relationship between the options and the underlying. But some options strategies can help hedge some options characteristics to achieve a more linear relationship between the two. We have the “Greeks,” which are characteristics that tell us the non-linearity level of an options pricing model. For additional information, they are called as such because the representations are from Greek letters like the delta and theta. We now learn that an underlying also plays a vital role in trading when it comes to options pricing.