Lookback Options

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Lookback options or hindsight options are a type of exotic option that allow the holder to buy or sell an underlying asset at its optimal price, lowest (for a put option) or highest (for a call option) price during a specified period, known as the "lookback period." This unique feature makes lookback options particularly useful for investors who want to take advantage of market fluctuations but are unsure about the direction of the market.[1][2] Unlike standardized options, lookback options are exclusively traded over-the-counter (OTC), meaning they are not listed on major exchanges. These cash-settled options provide a settlement amount based on the best price differential during the purchase period. However, their benefits come at a high execution cost.[3]

Trading Strategy[edit]

The trading strategy for lookback options involves capitalizing on the underlying asset's price movements during the lookback period. Here's how it works:

Lookback Call Option[edit]

The investor purchases a lookback call option with a specified strike price and lookback period. During the lookback period, the investor monitors the underlying asset's price movements.

At expiration, the investor can exercise the option and buy the underlying asset at the lowest price it reached during the lookback period, regardless of the current market price.

For example, if the underlying asset's price reached a high of $60 during the lookback period, the investor can exercise the option and buy the asset at the strike price, even if the current market price is lower.

Lookback Put Option[edit]

The investor purchases a lookback put option with a specified strike price and lookback period.

During the lookback period, the investor monitors the underlying asset's price movements.

At expiration, the investor can exercise the option and sell the underlying asset at the highest price it reached during the lookback period, regardless of the current market price.

For example, if the underlying asset's price reached a low of $40 during the lookback period, the investor can exercise the option and sell the asset at the strike price, even if the current market price is higher.

Applications[edit]

Lookback options can be used in various markets, including:

  • Stock Market: Traders can use lookback options to take advantage of price fluctuations in individual stocks or stock indices.
  • Commodity Market: Farmers and commodity traders can use lookback options to lock in favorable prices for their products during the lookback period.
  • Currency Market: Companies with exposure to foreign currency exchange rates can use lookback options to reduce risk and lock in profits.
  • Real Estate Market: Buyers can use lookback options to purchase properties at the lowest price during the lookback period, even if the current market price is higher.

Pricing and Risk Management[edit]

Pricing lookback options can be complex due to their path-dependent nature. Various pricing models, such as the binomial option pricing model and Monte Carlo simulations, have been developed to accurately price these options. Additionally, lookback options can be used as a risk management tool, allowing investors to hedge against extreme volatility and mitigate exposure to market fluctuations.

References[edit]