Introduction to Lookback Options
A lookback option allows the holder to exercise the option at the most advantageous price of the underlying asset throughout the option’s duration, significantly minimizing potential regrets and missed opportunities.
Key Takeaways
- Lookback options empower buyers to leverage historical price movements, thus reducing the uncertainty in market decisions.
- These options are exclusively available over-the-counter (OTC) and are not listed on major exchanges.
- Establishing lookback options comes with substantial costs, which may offset potential profits.
- Fixed strike and floating strike lookback options offer unique solutions to market exit and entry challenges, respectively.
Delving Into Lookback Options
Known also as hindsight options, lookback options offer the luxury of hindsight when deciding the optimal point to exercise the option. These options are beneficial for mitigating timing risks related to market entry and ensuring that the options don’t expire worthless. The luxury comes at a premium as lookback options are more expensive to execute.
As an exotic type of option, a lookback option allows the holder to review the historical prices of the underlying asset during the lifespan of the option to select the most beneficial exercise point. By focusing on the widest differential between the strike price and the historical market prices, holders can maximize their potential gains.
These financial instruments are cash-settled, meaning that the final settlement is based on the most advantageous difference between the high and low prices during the option’s life. The calculation at settlement provides cash reflective of those differences minus the initial cost.
Fixed vs. Floating Lookback Options
Fixed Strike Lookback Options
In a fixed strike lookback option, the strike price is established at the time of purchase. Unlike traditional options, the exercise leverages the historical price that provides the highest potential return for calls or the highest gain for puts.
- Call Option: The holder can choose to exercise at the asset’s highest historical price during the contract term.
- Put Option: The holder can select the asset’s lowest historical price, ensuring maximum gain.
The settlement is compared against this beneficial historical price and the initial strike to compute profitability.
Floating Strike Lookback Options
Conversely, with a floating strike lookback option, the strike price adjusts automatically at maturity to the most favorable historical price achieved.
- Call Option: The strike price is the lowest price, set at maturity.
- Put Option: The strike price is the highest price, applied at maturity.
In this scenario, the differential is reviewed at the option’s end to determine the profit or loss metrics.
Real-World Examples of Lookback Options
Example 1: Stable Stock Price
Assume a stock starts and ends at $50 over three months, with highs of $60 and lows of $40 during this period.
- Fixed Strike Call: Strike is $50; best price is $60. Profit = $60 - $50 = $10.
- Floating Strike Call: Lowest past price is $40; settles at $50. Profit = $50 - $40 = $10.
Although the net movement is zero, leveraging historical prices ensures gains.
Example 2: Net Gain Situation
Assuming the same price fluctuations but closing at $55.
- Fixed Strike Call: Highest price remains $60, initial strike $50. Profit = $60 - $50 = $10.
- Floating Strike Call: Adjustment at closure $55; Best price leverage $40. Profit = $55 - $40 = $15.
Example 3: Net Loss Situation
Consider if the stock closes at $45, for a net loss of $5.
- Fixed Strike Call: Highest value $60, initial strike $50. Profit = $60 - $50 = $10.
- Floating Strike Call: Sets at closure price $45, lowest observed $40. Profit = $45 - $40 = $5.
Conclusion
Lookback options offer distinct advantages for traders seeking to capitalize on market price movements effectively. Whether opting for fixed or floating strikes, these options provide a strategic edge, minimizing timing conflicts and boosting profit potential. While the setup costs are significant, the trade-offs include lower risk and increased financial rewards for those capable of leveraging market behaviors adeptly.
Related Terms: exotic options, strike price, underlying asset, cash-settled options, call options, put options, option maturity.
