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Lookback Option

Lookback Option
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What Is a Lookback Option?

A lookback option allows the holder to exercise an option at the most beneficial price of the underlying asset, over the life of the option.

Figuring out Lookback Options

Otherwise called a hindsight option, a lookback option allows the holder the advantage of knowing history while deciding when to exercise their option. This type of option decreases vulnerabilities associated with the timing of market entry and diminishes the possibilities the option will lapse worthless. Lookback options are costly to execute, so these advantages include some major disadvantages.

As a type of exotic option, the lookback allows the client to "think back," or survey, the prices of a underlying asset over the lifespan of the option after it has been purchased. The holder may then exercise the option in light of the most beneficial price of the underlying asset. The holder can exploit the greatest differential between the strike price and the price of the underlying asset. Lookback options don't trade on major exchanges. All things being equal, they are unlisted and trade over-the-counter (OTC).

Lookback options are cash-settled options, and that means the holder gets a cash settlement at execution in view of the most advantageous differential among high and low prices during the purchase period. Venders of lookback options would price the option at or close to the most extensive expected distance of price differential in light of past volatility and demand for the options. The cost to purchase this option would be taken front and center. The settlement will compare to the profits they might have produced using buying or selling the underlying asset. In the event that the settlement was greater than the initial cost of the option, the option buyer would have a profit at settlement, otherwise a loss.

Fixed versus Floating Lookback Options

While utilizing a fixed strike lookback option, the strike price is set or fixed at purchase, like most other types of option trades. In contrast to other options, notwithstanding, at the hour of exercise, the most beneficial price of the underlying asset over the life of the contract is utilized rather than the current market price. On account of a call, the option holder can survey the price history and decide to exercise at the point of highest return potential.

For a put option, the holder might execute at the asset's lowest price point to understand the best gain. The option contract settles at the chose past market price and against the fixed strike.

While utilizing a floating strike lookback option, the strike price is set automatically at maturity to the most positive underlying price came to during the contract's life. Call options fix the strike at the lowest underlying asset price. Adversely, put options fix the strike at the highest price point. The option will then settle against the market price ascertaining the profit or loss against the floating strike.

The fixed strike option tackles the market exit issue — the best chance to get out. The floating strike takes care of the market entry issue — the best chance to get in.

Instances of Lookback Options

In model number one, in the event that you expect a stock trades at $50 at both the beginning and end of the three-month option contract, so there is no net change, gain, or loss. The path of the stock will be no different for both the fixed and floating strike adaptations. At a certain point during the life of the option, the highest price is $60, and the lowest price is $40.

  • For a fixed strike lookback option, the strike price is $50. The best price during the lifespan is $60. At strike, the stock is $50. The profit for the call holder is $60 - 50 = $10.
  • For a floating strike lookback option, the lowest price during the lifespan is $40. At maturity, the stock is $50, which is the strike price. The holder's profit is $50 - 40 = $10.

The profit is the equivalent in light of the fact that the stock moved a similar amount higher and lower during the life of the option.

In model number two, we should expect the stock had a similar high of $60 and low of $40, however closed toward the finish of the contract at $55, for a net gain of $5.

  • For a fixed strike lookback option, the highest price is $60. The strike price is $50, which was set at purchase. Profit is $10 (60 - 50 = 10).
  • For a floating strike lookback option, the strike price is $55, which is set at option maturity. The lowest price is $40. Creating a gain of $15 (55 - 40 = 15).

At last, in model number three, we should expect the stock closed at $45 for a net loss of $5.

  • For a fixed strike lookback option, the highest price is $60. Less the strike price of $50, which was set at purchase. Gives a profit of $10 (60 - 50 = 10).
  • For a floating strike lookback option, the strike price is $45, which is set at option maturity. Less the lowest price of $40, Gives a profit of $5 (45 - 40 = 5).

Highlights

  • Lookback options are just accessible "over-the-counter" (OTC) and not on any of the major exchanges.
  • Lookback options are costly to lay out and the potential profits are many times invalidated by the costs.
  • Fixed strike lookback option takes care of the market exit issue — the best chance to get out, while the floating strike lookback option tackles the market entry issue — the best opportunity to get in.
  • Lookback options are exotic options that allow a buyer to limit regret.