Underlying market definition
What do underlying market and underlying asset mean?
An underlying market is the market on which a derivative is based. This might also be called an underlying asset. You can trade derivatives contracts based on many underlying markets, from commodities such as oil and gold, to stock indices, to spot forex.
Underlying assets and underlying markets used in trading
Derivatives are financial instruments where the value is based on an underlying asset. Derivatives contracts such as binary options, knock-outs and call spreads can be based on many different types of underlying assets.
These are some examples of underlying assets that might be used in trading:
Specific commodities, such as gold or a barrel of oil
Underlying markets don’t always have to be based on individual assets like these. They might be based on futures contracts, the figures in a specific economic release, or any other market offered by an exchange or trading provider.
Examples of underlying markets include:
Stock index futures
Events or economic releases
How do underlying markets and assets relate to derivatives?
The price movement of the underlying market also affects derivatives that are based on it. For example, if the price of an oil futures contract goes up, the value of a derivative based on that oil futures contract would also tend to go up. The exact nature of the relationship between a contact and its underlying market will depend on the derivative itself.
Underlying market pricing
Markets have what’s called an indicative price, which shows the current underlying market price in a way that’s useful for traders. Let’s look at three types of derivatives and how their pricing relates to the underlying markets they’re based upon:
Binary options. The price of the contract isn’t predetermined by a fixed formula or decided by Nadex – it’s decided by the buyers and sellers themselves. When the indicative price (based on the underlying market price) is higher, sellers will demand more for the contract, and buyers will be willing to pay extra.
Knock-outs and call spreads. The indicative price tracks the underlying market and moves in a similar fashion. You trade with set boundaries, which behave differently depending on the contract type:
Knock-outs expire if the upper or lower boundary is hit, giving you your maximum potential profit or loss.
Call spreads only expire at the end of the contract duration, but the boundaries give you a natural profit target and stop loss level.
Learn more about underlying markets/assets
To get a thorough understanding of underlying markets and how they relate to trading, you need to see them in action. Open a Nadex demo account and practice trading contracts based on stock index futures, spot forex, commodities futures, and events. You’ll get $10,000 in virtual funds to see what it’s like trading on these underlying markets.
Open a Nadex demo account to get started.