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.

Other names include correlation options and basket options.

BREAKING DOWN 'Rainbow Option'

Rainbow options have several difference varieties, depending on how the performances of each underlying asset are considered. Some pay off based on the best or worst performance among the underlying assets. In other words, it looks at the top or bottom performance and pays off based on that single asset. These are sometimes called "best of" or "worst of" rainbow options.

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 also rainbow options since their payoff is based on the total or net performance of all 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.

Correlation Options are rainbow options are regular options on one asset that are only activated when a second 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 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 bet must finish in the top three in any order. If they do not, then the bet, and the option, expires worthless.

For stocks, it could be an option that pays off based on which of a 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 to 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 energy that activates if the U.S. dollar falls significantly.

Strategies can be infinitely 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.

RELATED TERMS
  1. Listed Option

    A listed option is a derivative security traded on a registered ...
  2. In The Money (ITM)

    In the money means an option has intrinsic value, which is determined ...
  3. Exotic Option

    An option that differs from common American or European options ...
  4. Call Option

    A call option is an agreement that gives the option buyer the ...
  5. Interest Rate Options

    An interest rate option is a financial derivative allowing the ...
  6. Russian Option

    An option that gives the holder the right, but not the obligation, ...
Related Articles
  1. Trading

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  2. Trading

    Stock Options: What's Price Got To Do With It?

    A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.
  3. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
RELATED FAQS
  1. 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 >>
  2. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  3. 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 >>
  4. Why do option volume quotes differ on different websites?

    Option quotes are different in price and in volume because identical options can trade on more than one market or exchange. ... Read Answer >>
Hot Definitions
  1. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  2. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  3. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  4. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  5. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  6. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
Trading Center