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.
- Lookback options are exotic options that allow a buyer to minimize regret.
- Lookback options are only available Over The Counter (OTC) and not on any of the major exchanges.
- These options are expensive to establish and the potential profits are often nullified by the costs.
How a Lookback Option Works
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 after it has been purchased. 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 major 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 based on the most advantageous differential between high and low prices during the purchase period. Sellers of lookback options would price the option at or near the widest expected distance of price differential based on past volatility and demand for the options. The cost to purchase this option would be taken up front. The settlement will equate to the profits they could have made from buying or selling the underlying asset. If the settlement was greater than the initial cost of the option, then the option buyer would have profit at settlement, other wise loss.
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).