What Is an Outperformance Option?

An outperformance option is a derivative where the payoff value is based on the relative performance of one asset compared with another. An outperformance option is a type of exotic option. Another way to view it is as a spread option with a strike price equal to zero. Outperformance options are typically, but not required to be, European-style and settled in cash. They trade in the over-the-counter market.

Outperformance options may also be referred to as "margrabe options".

Understanding Outperformance Options

An outperformance option basically pits the performance of one asset against another, with the difference being the gain for the investor. For example, an investor may purchase an outperformance option, where they gain if the S&P 500 outperforms the FTSE 100 over a six-month period. If at the end of the six months the S&P 500 outperforms the FTSE 100, the option holder will gain. However, if the S&P has underperformed the FTSE 100 over this time period, the option will expire worthless.

It is worth noting that each asset may have vastly different nominal prices. For example, with stock A trading at $5 and stock B trading at $200, the nominal spread is not a good measure of performance. Stock A may gain $1 and stock B may gain $2 over the life of the option, however, the percentage gain for A would be 20% and for B would be 1%. In this case, stock A greatly outperformed stock B over the life of the option although the gains in dollar terms was half that of stock B. So outperformance options consider the same value of each asset at the start of the contract. The spread then looks at the increase or decrease in relative value between the two assets.

Uses for Outperformance Options

Outperformance options have a few common uses. The main one is how these options allow speculators to bet on the performance of two assets relative to each other. Speculators can choose two stocks, two county indexes, two sectors or two of any other asset not necessarily even in the same class. Moreover, outperformance options can be useful in foreign exchange when there is no direct cross rate available to trade. Similarly, in the bond market, they can be used to compare the performance of two different issuers.

Hedgers also find outperformance options useful for reducing risks across markets or assets. For example, two similar companies in different countries may be affected by their own country's interest rates or currencies. If the holder believes both companies have similar prospects but one has additional risks due to their home market, the option can help mitigate that risk.