Underlying Market

1. Underlying Market

The Underlying Market is a foundational concept in financial trading, particularly crucial for understanding derivatives like options, futures, and contracts for difference (CFDs). This article will provide a comprehensive explanation for beginners, covering its definition, types, how it relates to derivatives, factors influencing it, risk management, and crucial concepts traders need to grasp.

What is the Underlying Market?

At its core, the underlying market refers to the actual asset upon which a derivative contract is based. It's the *primary* market where the asset is bought and sold directly. Think of it as the origin point for all related derivative trading. The price movement in the underlying market directly impacts the prices of its corresponding derivatives.

Consider a simple example: Apple stock (AAPL) is an underlying asset. An option contract that gives you the right to buy or sell AAPL at a specific price is a derivative. The price of that option is determined, in large part, by the price of Apple stock in the underlying market – the stock exchange (like the NASDAQ).

The underlying market isn’t limited to stocks. It can encompass a vast range of assets, including:

• Stocks/Equities: Shares of publicly traded companies. This is the most common underlying asset. Stock Market
• Indices: Statistical measures of a segment of the stock market, like the S&P 500, Dow Jones Industrial Average, or NASDAQ Composite. Stock Index
• Currencies (Forex): The foreign exchange market, where currencies are traded against each other (e.g., EUR/USD, GBP/JPY). Foreign Exchange Market
• Commodities: Raw materials or primary agricultural products, such as gold, oil, wheat, or corn. Commodity Market
• Bonds: Debt securities issued by governments or corporations. Bond Market
• Cryptocurrencies: Digital or virtual currencies using cryptography for security. Cryptocurrency

How Derivatives Relate to the Underlying Market

Derivatives derive their value from the underlying market. They are contracts *based on* the performance of that asset, rather than direct ownership of it. Let's break down the key relationships:

• Options: Give the buyer the *right*, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a predetermined price (strike price) on or before a specific date (expiration date). The price of an option (the premium) is influenced by the underlying asset’s price, volatility, time to expiration, and interest rates. Options Trading
• Futures: Obligate the buyer to purchase, and the seller to sell, the underlying asset at a predetermined price on a specific future date. Futures contracts are commonly used for commodities and financial instruments. Futures Trading
• CFDs (Contracts for Difference): An agreement to exchange the difference in the price of the underlying asset from the time the contract is opened to the time it is closed. CFDs allow traders to speculate on price movements without owning the underlying asset. CFD Trading
• Forwards: Similar to futures but are customized contracts traded over-the-counter (OTC) rather than on an exchange.

The price of these derivatives is heavily correlated with the price of the underlying market. If the underlying asset's price increases, call options generally increase in value, and put options generally decrease. Futures and CFDs will also reflect the price movement, although leverage can amplify both gains and losses. Understanding this relationship is paramount for successful trading.

Factors Influencing the Underlying Market

Numerous factors can influence the price movements within an underlying market. These can be broadly categorized into:

• Economic Factors: These are macroeconomic forces that affect the overall economy and, consequently, asset prices.

   *   Interest Rates:  Higher interest rates can make borrowing more expensive, potentially slowing economic growth and impacting stock prices. Interest Rate
   *   Inflation:  Rising inflation erodes purchasing power and can lead to central banks raising interest rates. Inflation
   *   Gross Domestic Product (GDP):  A measure of a country's economic output. Strong GDP growth typically supports stock prices. GDP
   *   Employment Data:  Unemployment rates and job growth figures provide insights into the health of the economy.  Employment
   *   Government Policies: Fiscal and monetary policies can significantly impact markets.

• Company-Specific Factors (for Stocks):

   *   Earnings Reports:  A company's financial performance, as revealed in its earnings reports, is a major driver of its stock price. Financial Statements
   *   News and Events:  Positive or negative news about a company can quickly impact its stock price.
   *   Management Changes:  Changes in leadership can signal shifts in a company's strategy.
   *   Product Launches:  Successful product launches can boost revenue and stock prices.

• Supply and Demand: The basic economic principle of supply and demand applies to all underlying markets. Increased demand relative to supply will generally drive prices up, while increased supply relative to demand will drive prices down.
• Geopolitical Events: Political instability, wars, and international relations can create uncertainty and affect markets.
• Market Sentiment: The overall attitude of investors towards a particular asset or the market as a whole. Market Psychology

Analyzing the Underlying Market: Tools and Techniques

Successfully trading derivatives requires a solid understanding of how to analyze the underlying market. Here are some key tools and techniques:

• Fundamental Analysis: Evaluating the intrinsic value of an asset by examining economic and financial factors. This involves analyzing financial statements, industry trends, and macroeconomic conditions. Fundamental Analysis
• Technical Analysis: Studying past price charts and trading volume to identify patterns and predict future price movements. Technical Analysis

   *   Chart Patterns: Recognizing formations on price charts that suggest potential future price movements (e.g., head and shoulders, double tops, triangles).  Chart Patterns Explained
   *   Trend Lines: Identifying the direction of price movement.  Trend Lines Guide
   *   Moving Averages:  Calculating the average price over a specific period to smooth out price fluctuations. Moving Averages Overview
   *   Relative Strength Index (RSI):  An oscillator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions. RSI Explained
   *   Moving Average Convergence Divergence (MACD):  A trend-following momentum indicator that shows the relationship between two moving averages of prices. MACD Explained
   *   Fibonacci Retracements:  Identifying potential support and resistance levels based on Fibonacci ratios. Fibonacci Retracements

• Sentiment Analysis: Gauging the overall mood of investors. Tools include news analysis, social media monitoring, and surveys.
• Volume Analysis: Examining trading volume to confirm price trends and identify potential reversals. Trading Volume
• Economic Calendars: Tracking upcoming economic releases that could impact markets. Economic Calendar

Risk Management in Relation to the Underlying Market

Trading derivatives carries inherent risks, and understanding the underlying market is crucial for managing those risks effectively.

• Volatility: The underlying market's volatility directly impacts the price of derivatives. Higher volatility generally leads to higher option premiums and increased risk. Volatility
• Liquidity: The ease with which an asset can be bought or sold. Illiquid underlying markets can make it difficult to execute trades at desired prices.
• Correlation: The relationship between the price movements of the underlying asset and its derivatives. Understanding correlation is vital for hedging and risk management.
• Diversification: Spreading investments across different underlying markets to reduce overall risk.
• Stop-Loss Orders: Automatically closing a trade when the price reaches a predetermined level to limit potential losses. Stop-Loss Order
• Position Sizing: Determining the appropriate amount of capital to allocate to each trade based on risk tolerance and account size. Position Sizing
• Hedging: Using derivatives to offset potential losses in the underlying market. Hedging Strategies

Different Underlying Market Types: A Closer Look

• Stock Indices: Trading index derivatives (like S&P 500 futures or options) allows exposure to a broad market segment, diversifying risk. However, it's crucial to understand the composition of the index and the factors influencing its performance. Index Funds
• Forex (Currency) Markets: Highly liquid and volatile, Forex markets are influenced by economic indicators, political events, and interest rate differentials. Pairs like EUR/USD and GBP/JPY are commonly traded. Currency Pair
• Commodity Markets: Prices are driven by supply and demand, geopolitical factors, and weather conditions. Trading commodity derivatives can provide diversification but requires understanding the specific dynamics of each commodity. Commodity Trading
• Cryptocurrency Markets: Highly volatile and speculative, cryptocurrency markets are influenced by news, regulatory developments, and technological advancements. Requires a high level of risk tolerance.

Advanced Concepts

• Implied Volatility: The market's expectation of future volatility, derived from option prices. Implied Volatility
• Greeks: Measurements of the sensitivity of an option's price to changes in underlying asset price, time to expiration, volatility, and interest rates. (Delta, Gamma, Theta, Vega, Rho) The Greeks Explained
• Volatility Skew and Smile: Patterns in implied volatility across different strike prices. Volatility Skew
• Black-Scholes Model: A mathematical model used to calculate the theoretical price of European-style options. Black-Scholes Model

Trading Strategy Risk Management Market Analysis Derivatives Options Futures CFDs Forex Trading Commodity Trading Technical Indicators

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners