Algorithmic trading has revolutionised financial markets, employing sophisticated strategies to execute trades automatically. Central to this are two fundamental concepts: underlying and instrument. While often used interchangeably, these terms encapsulate distinct elements crucial for traders and investors navigating the complexities of automated algo trading. Read on to find out what the seven key differences between underlying and instrument are.
1. Definition and Conceptual Variance
Underlying refers to the primary asset or security on which a derivative contract is based. It represents the foundational element driving the value of a derivative. It serves as the basis for the derivative’s price movement. The underlying asset can encompass various financial instruments or tangible assets. In options, futures, or other derivative contracts, the value is directly linked to the underlying asset’s price fluctuations. Examples of underlying assets:
- Stocks: An individual stock (like Apple Inc., Google, etc.)
- Indices: Market indices such as the S&P 500, Dow Jones Industrial Average, etc.
- Commodities: Gold, crude oil, wheat, etc.
- Currency Pairs: Euro/USD, GBP/JPY, etc.
- When it comes to algo trading in India, there are stocks like Reliance Industries Limited and Infosys and indices like Nifty 50 and Sensex.
In options trading, for instance, when an investor buys a call option on a stock, the stock itself is the underlying asset. The value of the call option fluctuates based on changes in the stock price.
An instrument is a broader term that encompasses various financial products or contracts traded in the market. It includes not only derivatives but also other securities like stocks, bonds, exchange-traded funds (ETFs), and more. Instruments can derive their value from the underlying asset, but they are distinct entities that are actively bought and sold on exchanges or over-the-counter markets. Types of instruments are:
- Derivatives: Options, futures, forwards, swaps, etc.
- Securities: Stocks, bonds, ETFs, etc.
- Other Financial Products: Mutual funds, structured products, etc.
Instruments provide investors and traders with diverse opportunities to participate in markets, manage risks, and speculate on price movements. Derivatives, in particular, derive their value from the underlying asset but function as separate contracts or products.
For example, consider a futures contract on crude oil. The crude oil itself is the underlying asset, while the futures contract is the instrument. The value of the futures contract fluctuates based on changes in the price of crude oil, but the contract itself is what traders buy and sell.
2. Nature of Relationship
The relationship between the underlying and instrument is intrinsic and indirect.
- The underlying asset influences the instrument’s value but does not directly represent it.
- For instance, an options contract on a stock derives its value from the stock’s price movements, but the option itself is a separate instrument traded in the market.
3. Market Accessibility and Liquidity
- Underlyings represent the foundational assets upon which derivatives or other financial instruments are based.
- These assets may or may not be directly tradable in the sense of purchasing or owning them outright.
- For example, market indices, like the S&P 500 or Dow Jones Industrial Average, cannot be purchased directly. Investors cannot buy shares of an index itself. Instead, financial products like index funds or ETFs replicate index performance.
- Instruments are tradable financial products or contracts that derive their value from these underlyings.
- Unlike the underlyings that might have limitations in direct trading, instruments are actively traded on exchanges or over-the-counter markets.
- Instruments are designed to provide investors with exposure to underlyings without the need to directly buy or hold those assets.
- They often have higher liquidity due to active trading on exchanges, enabling investors to enter and exit positions more easily.
4. Derivative Vs Actual Ownership
One of the fundamental distinctions lies in ownership.
- Underlyings: Investors investing in the underlyings hold tangible ownership, such as owning shares of a company or physical commodities. To enhance trading confidence, it’s advisable to conduct backtesting to validate a trading strategy. uTrade Algos, an algorithmic trading platform, proves valuable by offering precise historical data, ensuring reliable analysis for traders.
- Instrument: When trading instruments, especially derivatives like futures or options, traders do not possess ownership of the underlyings. Instead, they hold contracts representing rights or obligations concerning the asset.
5. Risk Profiles and Volatility
- Risk Profile: Underlyings represent the inherent risk of the core assets themselves, like stocks, commodities, indices, etc. The risk associated with these assets is generally based on factors specific to the asset type, such as market conditions, economic changes, industry trends, or company performance. On uTrade Algos, an array of expert-endorsed algorithms will assist you. Tailored strategies for various market situations, called uTrade Originals, provide a firsthand experience of the prowess of algorithmic trading.
- Volatility: The inherent volatility of underlyings indicates how much their prices typically fluctuate over time. For instance, stocks might experience price swings due to company news, market sentiment, or broader economic factors. Commodities might fluctuate based on supply-demand dynamics, geopolitical events, or weather conditions.
- Risk Profile: Instruments, especially derivatives like options, futures, or swaps, have their own risk characteristics that differ from their underlying assets. They often exhibit distinct risk profiles due to factors like leverage, time decay (in options), implied volatility changes, or derivative-specific complexities. The risk profile of these instruments is influenced by factors beyond the underlying asset’s dynamics.
- Volatility: Instruments, particularly derivatives, can experience higher volatility compared to the underlying assets. This increased volatility is often due to the amplification of risk caused by factors like leverage, derivative-specific dynamics, and the sensitivity of these instruments to changes in market conditions. As a result, they might display faster and larger price movements than the underlying assets they are based on.
6. Pricing Mechanisms and Factors
- The pricing of underlyings is influenced by fundamental market forces, supply-demand dynamics, economic indicators, and asset-specific factors.
- Contrastingly, instruments’ prices are determined by various factors, including the underlying asset’s price movements, time decay (for options), implied volatility, interest rates, and dividends.
7. Purpose and Market Functionality
- Underlyings serve as the foundation upon which financial products and derivative contracts are structured.
- They enable risk management, hedging, and speculation through instruments.
- Instruments, as tradable entities, facilitate market activities, providing avenues for investors and traders to capitalise on price movements without owning the underlying asset.
Understanding the nuanced differences between underlying and instrument is pivotal in navigating the landscape of algorithmic trading. While the underlying asset forms the bedrock, instruments offer avenues for leveraging opportunities, managing risk, and participating in diverse financial markets. Mastering these distinctions empowers traders and investors to craft sophisticated automated algo trading strategies, harnessing the interplay between underlyings and instruments for optimised trading outcomes in dynamic market environments.