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 structures can be rather exotic and made for institutional clients when referring to financial assets.

Key Takeaways

  • A rainbow option is an exotic option usually available only to institutional investors.
  • Rainbow options come in different types and are usually dependent on multiple variables and underlyings. They are usually structured so that the option only activates once certain parameters are triggered.

Other names include correlation options and basket options. In general, rainbow options are structured as calls and/on puts on the best of or worst of as it relates to the underlying asset.

How a Rainbow Option Works

Rainbow options can be structured in many ways 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 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.

Correlation options are a type of rainbow option. An example would be a correlation on 2 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.

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 in the 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 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 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.