What is a 'Lookback Option'

Also known as a hindsight option, a lookback option allows the holder the advantage of knowing history when determining when to exercise their option. This type of option reduces uncertainties associated with the timing of market entry and reduces the chances the option will expire worthlessly. Lookback options are expensive to execute, so these advantages come at a cost.

BREAKING DOWN 'Lookback Option'

As a type of exotic option, the lookback allows the user to "look back," or review, the prices of an underlying asset over the lifespan of the option. The holder may then exercise the option based on the most beneficial price of the underlying asset. The holder can take advantage of the widest differential between the strike price and the price of the underlying asset. Lookback options do not trade on formal exchanges. Instead, they are unlisted and trade over-the-counter (OTC).

Lookback options are cash settled options, which means the holder receives a cash settlement at execution.  The settlement will equate to the profits they could have made if buying or selling the underlying asset.

Lookback options are available in two varieties, fixed strike price and floating strike price. They are available for both call and put options.

Fixed vs. Floating Lookback Options

When using a fixed strike lookback option, the strike price is set or fixed at purchase, similar to most other types of option trades. Unlike other options, however, at the time of exercise, the most beneficial price of the underlying asset over the life of the contract is used instead of the current market price. In the case of a call, the option holder can review the price history and choose to exercise at the point of highest return potential. For a put option, the holder may execute at the asset's lowest price point to realize the greatest gain. The option contract settles at the selected past market price and against the fixed strike.

When using a floating strike lookback option, the strike price is set automatically at maturity to the most favorable underlying price reached during the contract's life. Call options fix the strike at the lowest underlying asset price. Adversely, put options fix the strike at the highest price point. The option will then settle against the market price calculating the profit or loss against the floating strike.

The fixed strike option solves the market exit problem - the best time to get out. The floating strike solves the market entry problem - the best time to get in.

Examples of Lookback Options

In example number one, if you assume a stock trades at $50 at both the start and end of the three-month option contract, so there is no net change, gain or loss. The path of the stock will be the same for both the fixed and floating strike versions. At one point during the life of the option, the highest price is $60, and the lowest price is $40.  

  • For a fixed strike lookback option, the strike price is $50. The best price during the lifespan is $60. At strike, the stock is $50. The profit for the call holder is $60 - 50 = $10.

  • For a floating strike lookback option, the lowest price during the lifespan is $40. At maturity, the stock is $50, which is the strike price. The holder's profit is $50 - 40 = $10.

The profit is the same because the stock moved the same amount higher and lower during the life of the option.

In example number two, let's assume the stock had the same high of $60 and low of $40, but closed at the end of the contract at $55, for a net gain of $5.

  • For a fixed strike lookback option, the highest price is $60. The strike price is $50, which was set at purchase. Profit is $10 (60 - 50 = 10).
  • For a floating strike lookback option, the strike price is $55, which is set at option maturity. The lowest price is $40. Making a profit of $15 (55 - 40 = 15).

Finally, in example number three, let's assume the stock closed at $45 for a net loss of $5. 

  • For a fixed strike lookback option, the highest price is $60. Less the strike price of $50, which was set at purchase. Gives a profit of $10 (60 - 50 = 10).
  • For a floating strike lookback option, the strike price is $45, which is set at option maturity. Less the lowest price of $40, Gives a profit of $5 (45 - 40 = 5).
  1. Put Option

    A put options gives the owner the right to sell a specified amount ...
  2. Out Of The Money (OTM)

    An out of the money option has no intrinsic value, but only possesses ...
  3. Digital Option

    Digital options have a fixed payout and risk, are based on price ...
  4. At The Money

    At the money is a situation where an option's strike price is ...
  5. Moneyness

    Moneyness is a description of a derivative relating its strike ...
  6. Bullet Trade

    A bullet trade is a secondary market trade that involves the ...
Related Articles
  1. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  2. Trading

    A Newbie's Guide to Reading an Options Chain

    Learning to understand the language of options chains will help you become a more effective options trader.
  3. Trading

    What Is Option Moneyness?

    In the money, at the money and out of the money define the current profitability of options positions.
  4. Trading

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
  5. 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.
  6. Trading

    Understanding Bull Spread Option Strategies

    Bull spread option strategies, such as a bull call spread strategy, are hedging strategies for traders to take a bullish view while reducing risk.
  1. Can an Option Have a Negative Strike Price?

    When it comes to exchange traded options, an option can't have a negative strike price. Read Answer >>
  2. 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 >>
  3. How Do Speculators Profit From Options?

    Options are a risky game, but you can learn speculators' tricks to use them to your advantage. Read Answer >>
  4. Does the seller (the writer) of an option determine the details of the option contract?

    The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between ... Read Answer >>
  5. After exercising a put option, can I still hold my option contract in order to sell ...

    Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to ... Read Answer >>
Trading Center