What Is a Balloon Option?
A balloon option is a contract where the strike price increases essentially after the underlying asset's price arrives at a predetermined threshold. A balloon option increases the investor's leverage on the underlying asset.
Understanding a Balloon Option
A balloon option is a type of exotic option. Exotic options are structured uniquely in contrast to commonplace American and European options. The structure of the strike price, payoff, type of underlying asset, and other factors can all shift. These options are complex and frequently used to hedge a specific risk. In the balloon option case, it's generally utilized when the underlying asset is a currency. Currency assets will quite often be more unstable.
A balloon option has a threshold price that, whenever surpassed, the ordinary payout is increased. This is favorable while dealing with currency or unpredictable assets. For instance, suppose that the option threshold is $100. After the underlying asset price surpasses $100, the strike price would balloon $2 for each $1 change in the asset price.
Exotic options are more uncommon and trade on the over-the-counter (OTC) market and are additionally generally less expensive than normal options. These options are generally held for more significant level portfolios and address quite certain circumstances.
While using balloon options, the investor, trader, or business might be looking to hedge specific moves in an asset or currency, whether up or down. Balloon options are valuable in hedging against an asset's movement within a specific reach, as the option may not pay out in the event that an asset price transcends or below a specific threshold.
Balloon Options and Barrier Options
A balloon option has a strike reset, of sorts, yet not at all like an European option with a strike reset feature, the balloon option strike price will continue to move alongside the underlying asset price movements. The strike reset option permits the option holder to reset the strike price to the spot price.
Barrier options have levels that the underlying asset price must trade at, or reach, to either knock-in or knock-out the option. That is, the option is similar as a "normal" option until the asset trades at the barrier price, which will either knock-out, become worthless, or knock-in.
In the interim, a balloon option is as yet active no matter what the asset price, however when it raises a ruckus around town price, the strike price moves per a predetermined ratio relative to the asset price. Suppose an investor needs to hedge currency risk for a specific reach, they could trade a balloon option.
In the event that the asset trades at $80, with a strike price of $100 and a threshold price of $110. The balloon ratio is 3-to-1, which is a $3 move in the strike price per $1 move in the asset price. When the asset price hits $110, the strike price will increase by $3 for each $1 move in the asset. In this way, the option may as yet expire being worthless. Assuming that the asset price is $116 at expiration, the option would lapse worthless, regardless of the initial strike of $100. That is on the grounds that the strike price ballooned to $118 in view of the 3-to-1 balloon ratio.
Balloon options ought not be mistaken for balloon payments, which are types of loans that don't completely amortize over the life of the loan. Toward the finish of a balloon loan's term, a balloon payment is expected to pay the outstanding principal balance of a loan. Balloon loans typically carry lower interest rates than loans with longer terms.
- A balloon option is a type of exotic option that is structured uniquely in contrast to normal American and European options, with variability in a large portion of the factors.
- An investor's leverage on the underlying asset is increased through a balloon option.
- Balloon options are over-the-counter (OTC) products and are most frequently utilized comparable to currencies and other unpredictable assets for the end goal of hedging.
- A balloon option is an option contract in which the strike price increases after the price of the underlying asset arrives at a predetermined threshold.