Path Dependent Option

What Is a Path Dependent Option?

A path dependent option is a exotic option that is value depends not just on the price of the underlying asset yet the path that asset took during all or part of the life of the option. There are many types of path-dependent options including Asian, chooser, lookback, and barrier options.

Understanding Path Dependent Options

All options give the holder the right, yet not the obligation, to buy or sell an underlying asset at a specific price, called the strike, before or at the expiration date. Options define the strike price and expiration date at the onset of the contract. Typically the price the underlying asset is trading at is compared to the strike price to determine profitability. In any case, in a path dependent option, what price is utilized to determine profitability can fluctuate. Profitability might be founded on an average price, or a high or low price, for instance.

There are two assortments of path dependent options:

1. Soft path dependent option — puts together its value with respect to a single price event that happened during the life of the option. It very well may be the highest or lowest traded price of the underlying asset or it very well may be a triggering event like the underlying touching a specific price. Option types in this group include barrier options, lookback options, and chooser options.
2. Hard path dependent option — considers the whole trading history of the underlying asset. A few options take the average price, tested at specific intervals. Option types in this group include Asian options, which are otherwise called average options.

Types of Path Dependent Options

Here is a short summary on several types of path-dependent options.

• Barrier Options: This category includes many sub-assortments, however for every one of them, the payoff relies upon whether the underlying asset comes to or surpasses a predetermined price. A barrier option can be a knock-out option, meaning it can lapse worthless in the event that the underlying surpasses a certain price. It can likewise be a knock-in option, meaning it has no value until the underlying arrives at a certain price. Barriers can be below the strike price, above it, or both.
• Lookback Options: Also known as hindsight options, lookback options allow the holder the advantage of knowing history while determining when to exercise their option. This type of option diminishes uncertainties associated with the timing of market entry and lessens the possibilities the option will lapse worthless. Lookback options are costly to execute, so these advantages include some significant pitfalls.
• Russian Options: A Russian is type of lookback option that doesn't have an expiration so the life of the option is anything the holder picks it to be. They are otherwise called decreased regret options.
• Chooser Options: This type of option allows the holder to conclude whether it is a call or put prior to the expiration date. Chooser options as a rule have a similar exercise price and expiration date paying little mind to what decision the holder eventually makes. Since they don't determine that the movement in the underlying asset be positive or negative, chooser options give investors a great deal of flexibility and will generally be more costly than conventional options.
• Asian Options: Here, the payoff relies upon the average price of the underlying asset over a certain period of time rather than standard options where the payoff relies upon the price of the underlying asset at a specific point on schedule (sale or maturity). These options allow the buyer to purchase (or sell) the underlying asset at the average price instead of the spot price.

Path Dependent Option Example

Expect that an investor needs to buy a average strike option on a stock, likewise called an Asian option. They might do this since they need their profitability in light of the average price over a set period of time, and not a single price at a given point on schedule or at expiry.

Expect the investor needs to buy a 30-day call option, where the settlement price is determined by the average of the 21 trading day (closing prices) in that particular month.

The strike price is $50. The underlying stock is as of now trading at $49.50. The option costs $1. Assuming the investor buys 100 contracts, the cost is $10,000 (100 contracts x $1 x 100 shares for every contract).

In order for the call buyer to bring in money, the average price of the next 21 trading days (closing prices) should be above $51. In the event that the average price is somewhere in the range of $50.01 and $50.99 they will have a partial loss. $51 is the breakeven point. Assuming the average price is below $50 they will lose the full $10,000 they bet.

The option is viewed as path-dependent on the grounds that the payoff will rely upon the price history of the stock. The price of the underlying stock on the day the option is sold or exercised has just a ¹/₂₁ impact on the average price that is utilized for settlement. In a vanilla option, the underlying price at expiry fully determines the value of the option.

Highlights

• A soft path dependent option puts together its value with respect to a single price event that happened during the life of the option.
• There are many types of path-dependent options including Asian, chooser, lookback, and barrier options.
• A path dependent option is an exotic option whose payout that can change in light of the path the underlying asset's price assumes control over its life or at certain times during the option's life.
• A hard path dependent option considers the whole trading history of the underlying asset.