What Is a Rainbow Option?

A rainbow option is an options contract linked to the performances of two or more underlying assets. They can speculate on the best performer in the group or minimum performances of all the underlying assets at one time. Each underlying may be called a color so the sum of all of these factors makes up a rainbow.

These are a type of exotic option that trade-the-counter (OTC). Rainbow options are similar to correlation options and basket options in that those also refer to a number of underlying securities; however, those types of options refer to a single price based on those underlying securities. Rainbow options are instead structured as calls and/or puts on the best or worst performer as it relates to the underlying assets involved.

Key Takeaways

  • A rainbow option is an exotic option that uses more than one underlying security.
  • Rainbow options come in different types and are usually dependent on either the best or worst performer of the multiple underlyings involved.
  • They are usually structured so that the option only activates once certain parameters are triggered.

How a Rainbow Option Works

Rainbow options can be structured in several ways depending on how the performances of each underlying asset are considered. Some pay off based on the best or worst performance among the covered underlying assets. In other words, its payoff is based on the top or bottom performer. These are sometimes called "best of" or "worst of" rainbow options.

A rainbow option could derive value, for instance, from three relatively low-correlated assets like the Russell 3000 Index of U.S. stocks, the MSCI Pacific Ex-Japan Index, and the Dow-AIG Commodity Futures Index. In a call rainbow written on these three indexes, the option would pay out the difference between the strike price and the level of the index that has risen by the largest amount of the three.

Spread options are technically rainbow options since their payoff is based on the difference in price between two underlying assets. Note that this is not the same as an options spread strategy, such as a vertical spread.

Basket options are similar since their payoff is based on the total or net performance of all of the underlying assets in the basket. However, the option is really only based on the value of the basket and not on any individual performances within. Unlike a basket option, all the assets underlying a rainbow option must move in the intended direction(s).

Correlation options are a type of rainbow option. An example would be a correlation between two or more assets, and the structure is only activated when an asset moves in or out of a specific range. They are similar to barrier options but correlation options depend on two underlying assets. Barrier options depend on a single underlying moving in or out of a range. Examples of barrier options include knock-in options and knock-out options.

Using Rainbow Options

In the horse racing betting world, a rainbow option can be similar to picking the top three finishers, called a trifecta box. All three horses in the bet must finish in the top three in any order. If they do not, then the bet, and the option, expires worthless.

In terms of stocks, a rainbow could be an option that pays off based on which pair of stocks moves up by the greatest percentage by the expiration date. For baskets of stocks, the payoff can be weighted based on the ranking of the stocks.

Perhaps a trader wants a call option on a currency that becomes active if and only if a benchmark interest rate moves outside of its current range. An airline might want a call option on a fuel commodity that activates if the U.S. dollar falls significantly.

Strategies can be quite complex, although the more complex, the less likely a seller will find a buyer to take the other side of the trade. Basically, if you can dream up a set of contingencies, you can create an option to speculate on it.