What Is a Balloon Option?
A balloon option is a contract where the strike price increases significantly after the underlying asset's price reaches a predetermined threshold. A balloon option increases the investor's leverage on the underlying asset.
- A balloon option is an option contract in which the strike price increases after the price of the underlying asset reaches a predetermined threshold.
- An investor's leverage on the underlying asset is increased through a balloon option.
- A balloon option is a type of exotic option that is structured differently than normal American and European options, with variability in most of the factors.
- Balloon options are over-the-counter (OTC) products and are most often used in relation to currencies and other volatile assets for hedging purposes.
Understanding a Balloon Option
A balloon option is a type of exotic option. Exotic options are structured differently than typical American and European options. The structure of the strike price, payoff, type of underlying asset, and other factors can all vary. These options are complex and often used to hedge a particular risk. In the balloon option case, it’s generally used when the underlying asset is a currency. Currency assets tend to be more volatile.
A balloon option has a threshold price that, if exceeded, the regular payout is increased. This is advantageous when dealing with currency or volatile assets. For example, let's say that the option threshold is $100. After the underlying asset price exceeds $100, the strike price would balloon $2 for every $1 change in the asset price.
Exotic options are less common and trade on the over-the-counter (OTC) market and are also generally cheaper than typical options. These options are generally reserved for higher-level portfolios and address very specific situations.
When using balloon options, the investor, trader, or business may be looking to hedge specific moves in an asset or currency, whether up or down. Balloon options are useful in hedging against an asset’s movement within a specific range, as the option may not pay out if an asset price rises too far above or below a particular threshold.
Balloon Options and Barrier Options
A balloon option has a strike reset, of sorts, but unlike a European option with a strike reset feature, the balloon option strike price will continue to move along with the underlying asset price movements. The strike reset option allows 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 much like a “normal” option until the asset trades at the barrier price, which will either knock-out, become worthless, or knock-in.
Meanwhile, a balloon option is still active regardless of the asset price, but when it hits the threshold price, the strike price moves per a predetermined ratio relative to the asset price. Let’s say an investor wants to hedge currency risk for a specific range, they might trade a balloon option.
If 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. Once the asset price hits $110, the strike price will increase by $3 for every $1 move in the asset. Thus, the option could still expire being worthless. If the asset price is $116 at expiration, the option would expire worthless, despite the initial strike of $100. That’s because the strike price ballooned to $118 based on the 3-to-1 balloon ratio.
Balloon options should not be confused with balloon payments, which are types of loans that do not fully amortize over the life of the loan. At the end of a balloon loan's term, a balloon payment is needed to pay the outstanding principal balance of a loan. Balloon loans usually carry lower interest rates than loans with longer terms.