What is Underwater?
Underwater is the term for an asset or a financial contract worth less than its notional value. This thing may be an out-of-the-money call option where the stock is currently priced above the strike price for the contract.
But, generally, the term is used in reference to a house or other significant asset that is associated with an outstanding mortgage or loan on it where it is greater than the value of the asset. In either case, the person has an asset that does not have an intrinsic value. In the case of mortgage or loan, the asset holder simply owes more than the value of the asset. Sometimes, it is referred to as upside-down underwater.
Break Down of Underwater
An out-of-the-money (OTM) call in options trading has a strike price above the market value of the underlying stock or commodity. An OTM holds a strike below the underlying current price. If the underlying asset is unable to travel past or below the call point, then the option will expire worthlessly.
This is because all the value of an OTM option is extracted from its time value and the ability to transfer in-the-money (ITM) at the underlying. If ITM does not pass, however, all that time value decays, leaving the option holder with a worthless asset. Traders use the OTM options when they assume that the underlying asset ultimately moves in the direction they want.
More generally, underwater means the ownership of an asset that is worth less than the outstanding loan amount on that asset. Such a scenario is possible in a margin trading account where a trader holds stock on leverage, but the company (stock) declares bankruptcy and the stock holdings no longer cover the broker's margin or loan to initially buy the stock.