An underlying asset in an option contract is the financial instrument on which the option is based. It could be a stock, commodity, currency, or futures contract. The underlying asset in an option contract is used to measure the value of an option. Options are financial derivatives, which allow investors to trade the right to buy or sell an underlying asset at a predetermined price and time.
For instance, if you purchase a call option for a specific stock, you are buying the right but not the obligation to purchase the underlying stock at a predetermined price called the strike price. In this case, the underlying asset is the stock itself, and the option contract gives you the right to buy the stock at a specific price, called the strike price. If the stock price increases beyond the strike price before the option expiry date, you can exercise the option to buy the stock at the strike price and then sell it for a profit.
Similarly, a put option gives the user the right to sell the underlying asset at a predetermined price before the expiry date. In this case, the underlying asset can be any financial instrument, such as a stock, commodity, currency, or futures contract. The put option`s value increases when the price of the underlying asset decreases.
The underlying asset is critical because it determines the value of the option. If the price of the underlying asset increases, the value of the call option increases, while the value of the put option decreases. On the other hand, if the price of the underlying asset decreases, the value of the put option increases, while the value of the call option decreases.
In conclusion, understanding the underlying asset in an option contract is crucial in trading options. It allows traders to evaluate the option`s value by analyzing the market forces driving the underlying asset`s price movements. As a professional, it`s essential to ensure that any content created on this topic is clear, concise, and easy to understand, using industry-specific terms sparingly to cater to a wider audience.