What Is a Ladder Option?
A ladder option is an exotic option that locks in partial profits 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.
How a Ladder Option Works
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.
Example of a Ladder Option
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.