Exotic options are options that have complex features than generally traded vanilla options. They have several triggers that determine their payoff. Lookback options are types of exotic options where the payoff depends on the maximum or minimum price of the underlying asset over the life of the option.
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What is a lookback option?
A lookback option is a type of exotic option where the holder has the advantage of having information about the history of the option when they decide when to exercise the option. Uncertainties related to the timing of market entry are reduced with this option. It also reduces the chances of the option expiring worthlessly. They are also called hindsight options.
How does it work?
A lookback option allows the holder to review the prices of the underlying asset over the lifetime of the option so that they can accordingly decide when it is best or most beneficial for them to exercise it. It helps them to “look back” overtime to decide the payoff.
The holder can take advantage of the wide difference in the strike price and the underlying asset price. These options don’t trade on major exchanges and instead are unlisted or traded over-the-counter (OTC). These options are cash-settled options.
Types of lookback options:
1. Fixed lookback options: In a fixed lookback option, like any other option, the strike price is fixed at the time of purchase. However, the option is not exercised at this price at maturity. Instead, the most beneficial price of the underlying asset over the lifetime of the option is used.
In a call option, the holder analyses the underlying asset’s price history and exercises the option at the point of highest potential. Whereas, in the case of a put option, the holder executes at the lowest price to get the most gain. This option solves the problem of market exit (the best time to get out).
2. Floating lookback options: In a floating lookback option, the strike price is set at maturity at the most favorable price that the underlying asset has over the lifetime of the contract.
In a call option, the strike price is automatically fixed at the lowest price of the underlying asset while in a put option, the strike price is set at the highest price. This option solves the problem of market entry (the best time to get in).
Suppose there is a stock trading at $100 at the start and end of a 3-month option contract. During the lifetime of the option contract, the highest price is $110 and the lowest price is $90.
For a fixed lookback option, the strike price is $100 and the highest price is $110. A strike, the price of the stock is $100. Hence, the profit for the call holder is $110-$100 = $10.
For a floating lookback option, the strike price, which is also the price at maturity is $100. The lowest price is $90. Hence, the profit for the holder is $100 – $90 = $10.
Trading in lookback options:
Lookback options generally don’t trade on major exchanges but are instead traded on unlisted or over-the-counter (OTC) markets. They are cash-settled options, so at execution, the holder receives a cash settlement depending on the most beneficial differential between high and low prices during the lifespan of the contract.
Since lookback options have strike prices at the lowest and highest point of the year, it is advantageous for investors who want to re-enter the market at the optimal time.
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Lookback options are a type of exotic option where the payoff is based on the maximum or minimum price of the underlying asset over the period of the contract. It can have a fixed strike or a floating strike. They are mostly traded on over-the-counter (OTC) markets and so are subject to the advantages and limitations of the same.
Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.