What it means
When you buy a call option on a company's shares, the shares are the underlying security. The option gives you the right to buy them at a fixed price, called the strike price, before a set date.
If the share price rises above the strike, the option gains value, and if it does not, the option may expire worthless. Underlying securities include common shares, bonds, exchange-traded funds and indices.
A convertible bond is another example, because it can be exchanged for the issuer's shares, which are the underlying security of the conversion right. Employee share options and warrants also rely on an underlying security.
The relationship between the derivative and the security matters for valuation. An option's value depends on the security's price, how volatile it is, how much time is left and the interest rate.
The security is also the source of dividends, and a dividend can change the value of options on it. Companies meet underlying securities in several ways.
A firm that grants share options to employees has the shares as the underlying security and must account for the cost. An investor who sells covered calls holds the underlying shares and gives up some upside in exchange for premium income.
Managers should also note that exercising an option can have an effect on the underlying security itself. In some cases new shares are issued, which dilutes existing shareholders, and in others existing shares are bought in the market.
Which one applies is set out in the terms of the contract. Investors should also remember that corporate actions on the underlying security can change the option.
A share split, a special dividend or a merger usually leads to an adjustment of the strike price or the number of shares covered. The exchange or the contract terms set out how the adjustment is made.
In practice
Real-world examples.
Example
An investor buys a call option on a technology company's shares for a premium of $3 a share. The shares are the underlying security, and the investor profits if the share price rises well above the strike plus the premium. If the shares do not rise, the most the investor can lose is the premium paid.
Example
A start-up grants employees options over 1,000,000 of its shares. The shares are the underlying security, and the company records the cost of the options over the vesting period. Investors read the note to see how many shares could be issued.
Example
A pension fund buys a convertible bond issued by a manufacturer. The bond can be converted into 40 shares per $1,000 of face value, so the manufacturer's shares are the underlying security of that conversion right.
Formula
Calculation
Intrinsic value of a call option = Maximum of (Price of underlying security - Strike price, 0)
An option gives the right to buy a share at a strike price of $50. The underlying security trades at $55, so the intrinsic value is 55 - 50 = $5 per share. For a contract covering 100 shares, the total intrinsic value is 5 x 100 = $500. If the share price were $45 instead, the intrinsic value would be zero, because the holder would not buy at $50 when the market price is $45.Case study
Seen in the real world.
Calderwood Retail is an illustrative, fictional listed company that offered share options to its senior managers. The options were based on its own shares as the underlying security, with a strike price set at the market price on the grant date.
Over three years, the share price rose from $20 to $32. The managers exercised options over 500,000 shares, and the company issued new shares, which increased the number of shares in issue and slightly diluted existing shareholders.
The illustrative lesson was that the finance team had to plan for the effects on the underlying security. It modelled the cost of dilution in its forecasts, told investors how many options were outstanding, and bought back shares in some years to limit the effect. The chief financial officer reported the net dilution each year in the annual report.
Watch out
Common mistakes.
- Thinking that owning the option means owning the underlying security, when the option only gives a right to buy or sell.
- Ignoring dividends and corporate actions, which can change the value of options on the security.
- Forgetting that exercising options may create new shares and dilute existing owners.
Questions
People also ask.
What is the difference between the underlying and the underlying security?
The underlying can be any reference asset, rate or index, whereas the underlying security is specifically a financial security such as a share or bond.
Does the option holder get dividends on the underlying security?
Not unless the option is exercised and the shares are owned before the dividend date.
Can an index be an underlying security?
An index is not a security itself, but index options and futures treat it as the reference, and some are settled in cash.
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