underlying security
Underlying security is the actual share, bond or asset that a derivative, option or note gets its value from, so if it moves, the derivative moves too.
In plain English
"Bros, so this MTN call option I bought, why did it just gain value when I did not touch MTN shares at all?" his cousin asked, staring at her trading app in confusion.
"Because you did not buy MTN shares," he said, laughing. "You bought a contract that follows MTN shares. MTN is the underlying security. Your option is just a shadow that moves when the real thing moves."
That is the whole idea. An underlying security is the actual asset, a share, a bond, a currency, sometimes even a stock index, that gives a derivative its reason to exist. The derivative itself, whether it is an option, a future or a structured note, has no value of its own. It borrows its value entirely from what is happening to the underlying security.
On the Nigerian Exchange, someone might trade a derivative product linked to Dangote Cement shares. Dangote Cement is the underlying security. If the share price climbs, the derivative tied to it climbs too, without anyone needing to own a single physical share.
In London, it works the same way. A trader holding an option on Barclays shares is not holding Barclays itself. Barclays is the underlying security, and the option simply tracks its fortunes, rising and falling in sympathy.
Even someone abroad sending money home can meet this idea indirectly, if they ever invest in an equity linked note built around Nigerian bank shares. The note's payout depends on those shares, its underlying security, doing well.
Chidi buys an option contract linked to Zenith Bank shares for ₦8,000. He never owns Zenith Bank shares directly, but Zenith Bank is the underlying security, so when its share price rises from ₦38 to ₦42, the value of Chidi's option rises with it.
Questions people ask
Is the underlying security the same as the derivative?
No. The underlying security is the real asset, like a share or bond. The derivative is a separate contract whose value depends on that asset's price movements.
Can an underlying security be something other than a share?
Yes. It can be a bond, a currency, a commodity, an interest rate or even an index made up of many shares combined.
Why does the underlying security matter to an everyday investor?
Because it tells you what actually drives your returns. If you do not understand the underlying security, you are trading blind on something you cannot properly judge.
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