What is a 'Ladder Option'

A ladder option is an exotic option that locks in partial profit once the underlying asset reaches predetermined price levels or "rungs." This guarantees at least some profit, even if the underlying asset retraces beyond these levels before the option expires. Ladder options come in put and call varieties.

Do not confuse ladder options, which are specific types of options contracts, with long call ladders, long put ladders, and their short counterparts, which are options strategies that involve buying and selling multiple options contracts simultaneously.

BREAKING DOWN 'Ladder Option'

Ladder options are similar to traditional option contracts that give the holder the right, but not the obligation to buy or sell the underlying asset at a predetermined price at or by a predetermined date. However, a ladder option adds a feature that allows the holder to lock in partial profits at predetermined intervals.

These intervals are fittingly called "rungs" and the more rungs the price of the underlying asset crosses, the more profit locks in. The holder keeps profits based on the highest rung achieved (for calls) or the lowest rung achieved (for puts) regardless if the price of the underlying crosses back below (for calls) or above (for puts) those rungs before expiration.

Because the holder earns non-returnable partial profits as the trade develops, total risk is much lower than for traditional vanilla options. The trade-off, of course, is that ladder options are more expensive than similar vanilla options.

Ladder Option Example

Consider a ladder call option where the underlying asset price is 50 and the strike price is 55. Rungs are set at 60, 65, and 70. If the underlying price reaches 62, the profit locks in at 5 (rung minus strike or 60 - 55). If the underlying reaches 71, then the locked in profit increases to 15 (new rung minus strike or 70 - 55), even if the underlying falls below these levels before the expiration date.

As with vanilla options, there is time value associated with ladder options. Therefore, the traded price for call options is usually above the locked in profit amount, and declining as the expiration date approaches.

If the price of the underlying falls below any of the triggered rungs, again for calls, it almost does not matter to the price of the option because the partial profit is guaranteed. Although, this is an oversimplification because the lower the underlying moves below the highest triggered rung, the less likely it will be to rally back to exceed that rung and reach the next rung.

RELATED TERMS
  1. Laddering

    Laddering is the promotion of inflated pre-IPO prices for the ...
  2. Exotic Option

    An exotic option is more complex or has a different structure ...
  3. Stock Option

    Stock options give the holder the right to buy or sell shares ...
  4. Put Option

    A put options gives the owner the right to sell a specified amount ...
  5. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
  6. Call on a Call

    A call on a call is a type of exotic option in which the investor ...
Related Articles
  1. Investing

    Build a Bond Ladder to Boost Returns

    If you want a diversified portfolio and steady cash flow, check out the fixed-income strategy known as laddering. Learn how to create a bond ladder.
  2. Managing Wealth

    What Is A CD Ladder?

    Find out how a CD ladder can protect you from interest rate risk.
  3. Trading

    Call options: Right to buy versus obligation

    Learn what a call option is, how buyers and sellers are determined, and what the difference between a right and an obligation is for options investors.
  4. Personal Finance

    The Toughest Corporate Ladders To Climb

    Which careers are the hardest to be promoted in? Here are some of America's toughest corporate ladders, and some tips on how to get ahead.
  5. Retirement

    Five Sources of Income for Your Retirement

    Generating income without going to work can be a murky concept. Find out how it works.
  6. Trading

    Option trading strategies: A guide for beginners

    Options offer alternative strategies for investors to profit from trading underlying securities. Learn about the four basic option strategies for beginners.
  7. Investing

    Why Options Trading Is Not for the Faint of Heart

    Trading options is not easy and should only be done under the guidance of a professional.
  8. Trading

    How to Sell Put Options to Benefit in Any Market

    The sale of a put allows market players to potentially own the underlying security at a future date, at a price below the current market price.
  9. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  10. Trading

    How to Make Money by Trading Index Options

    Index options are less volatile and more liquid than regular options. Understand how to trade index options with this simple introduction.
RELATED FAQS
  1. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  2. What Happens to Call Options If a Co. is Bought?

    Typically, the announcement of a buyout offer by another company is a good thing for shareholders. Read Answer >>
  3. How does a forward contract differ from a call option? (AAPL)

    Find out more about forward contracts, call options, the mechanics of these financial instruments and the difference between ... Read Answer >>
Trading Center