What is a Path Dependent Option

A path dependent option is an exotic option that's value depends not only on the price of the underlying asset but the path that asset took during all or part of the life of the option. 

There are many types of path-dependent options including Asian, chooser, lookback and barrier options.

BREAKING DOWN Path Dependent Option

All options give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price during a specified time period. Standard options define the strike price and expiration date at the onset of the contract. However, some options do not define these parameters, leaving them up to the holder and/ or to the path the underlying asset takes to decide.

There are two varieties of path dependent options. One type, called a soft path dependent option, bases its value on a single price event that occurred during the life of the option. It could be the highest or lowest traded price of the underlying asset or it could be a triggering event such as the underlying touching a specific price. Option types in this group include barrier options, lookback options and chooser options.

The other type, called a hard path dependent option, takes into account the entire trading history of the underlying asset. Some options take the average price, sampled at specific intervals. Option types in this group include Asian options, which are also known as average options.

Intro to Path Dependent Varieties

Barrier Options - This category includes many sub-varieties but for all of them, the payoff depends on whether or not the underlying asset reaches or exceeds a predetermined price. A barrier option can be a knock-out option, meaning it can expire worthless if the underlying exceeds a certain price, limiting profits for the holder but limiting losses for the writer. It can also be a knock-in option, meaning it has no value until the underlying reaches a certain price. Barriers can be below the strike price, above it or both.

Lookback Options - Also known as hindsight options, lookback options allow 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 worthless. Lookback options are expensive to execute, so these advantages come at a cost.

Russian Options - This is a type of lookback option that does not have an expiration so the life of the option is whatever the holder chooses it to be. They are also known as reduced regret options.

Chooser Options - This type of option allows the holder to decide whether it is a call or put prior to the expiration date. Chooser options usually have the same exercise price and expiration date regardless of what decision the holder ultimately makes. Because they don't specify that the movement in the underlying asset be positive or negative, chooser options provide investors a great deal of flexibility when evaluating volatile issues.

Asian Options - Here, the payoff depends on the average price of the underlying asset over a certain period of time as opposed to standard options where the payoff depends on the price of the underlying asset at a specific point in time (sale or maturity). These options allow the buyer to purchase (or sell) the underlying asset at the average price instead of the spot price.