What is a 'Chameleon Option'

A chameleon option has the ability to change its structure should predetermined terms of the contract be met, such as a specified increase or decrease in the price of the underlying asset. A chameleon option gives an investor greater flexibility in that they can trade a chameleon option instead of trading multiple vanilla options to attain the same result. 

Breaking Down the 'Chameleon Option'

Chameleon options are traded over the counter (OTC) and are therefore customizable based on what the buyer and seller agree on. In simplest terms, I chameleon option could be both a call or put, depending on which side of the strike price the underlying asset is on. If the underlying is above the strike price it could be a call option, and if the underlying's price is below the strike price, then it could be a put option. If a trader expected a large move in a stock, but was unsure of the direction, instead of buying both a call and put they could purchase a chameleon option structured like this.

The advantage of the chameleon option is its flexibility. The parties can agree to their own strike price, expiration date, contract size, whether its a call or put, and at which intervals any of these variables change.

The disadvantages include a higher premium than a vanilla option, primarily because the chameleon offers a greater chance of the option finishing in the money  (depending on the terms). The seller of the option, therefore, demands a higher cost for the option. That said, the cost of the chameleon may be more attractive than buying multiple vanilla options. OTC options aren't liquid, so it may not be possible to get out of the option prior to expiry if needed. These options are primarily traded by sophisticated and high net worth individuals and institutions, and are rarely used by the average investor.

Chameleon Option Example

These types of options are highly customizable, so the following is just one possible way it could be structured. 

Assume a trader wants to buy an at the money call option that expires in one month. The underlying stock is trading at $45, so the strike price on the chameleon option is also $45.

Due to a major news event coming out in the stock the buyer of the option also wants some downside protection. If the stock falls below $40 they want the call turned into a put option.

The chameleon option has given the trader essentially two options in one. They have a call option if the price of the underlying rises, and they have a put option if the underlying falls below $40.

Assuming a $45 strike vanilla option, that expires in one month, is trading for $1, and the $40 put is trading at $0.08, then the price of the chameleon will likely be around $1.08, and possibly slightly less since both parties save on transaction fees and the seller may wish to induce the buyer to trade the chameleon instead of simply buying a call and put if it is cheaper to do so.

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