What Is a Russian Option?
A Russian option, also known as a "reduced regret option," is a type of exotic option that contains a lookback provision as well as no expiration date. This means that the holder of a Russian option can wait as long as they want before exercising it, and can even do so at the most favorable price that it has ever traded for, regardless of its current price.
In practice, Russian options are rarely used as they would likely require very large premiums due to the highly favorable terms enjoyed by the option holder.
- Russian options are exotic options that have both a lookback provision and no expiration date.
- The holder of these options can exercise them whenever they want, at the best price the underlying security has ever sold for.
- Russian options were first proposed in a 1993 academic paper.
- Russian options are seldom (if ever) traded in reality and are primarily a topic of academic interest.
Understanding Russian Options
The concept of the Russian option was first proposed by Larry Shepp and A. N. Shiryaev, in a 1993 article published in the academic journal The Annals of Applied Probability. They described a type of "new put option" in which the option holder has the right to hold the option indefinitely, exercise the contract at any time, and, upon executing the contract, receive either the current price or the maximum price (discounted) at which the option ever traded in the past. "The buyer need look at the fluctuations [between the purchase time and the exercise time] only occasionally and enjoys having little or no regret that he did not exercise the option at an earlier time (except for the discounting)," the authors wrote.
"We call it the Russian option, partly to distinguish it from the American and European options, where the term of the option is prescribed in advance and where no exact formula for the value has been given," Shepp and Shiryaev added. However, "to our knowledge, no such regretless option is currently traded in any existing market despite its evident appeal."
Indeed, most investors would love to own such an option since it is extremely favorable to the option holder. However, while the Russian option concept has led to much academic discussion, it has never been put into regular use. If it were implemented in reality, it would likely be traded over the counter (OTC) and would require substantial premiums. These constraints might largely eliminate the attractiveness of Russian options for most real-world traders.
Although the Russian option is not traded in practice—at least, no major exchange or market offers it—it has led to the development of several remarkable formulas for the option value, optimal exercise time, and the expected exercise time, which have had an important impact on probability theory.
In 1995, Shepp and Shiryaev published a follow-up paper, "A New Look at Pricing of the 'Russian Option,'" which offered a simplified way to calculate a fair value for the option.
Example of a Russian Option
Brad is an options trader who enjoys investing in exotic options through OTC transactions. He manages to find a counterparty willing to negotiate a Russian option, which is almost never traded in reality.
Brad and his counterparty agree on the following terms: The contract is written as a put option in which Brad is the option holder and in which the underlying asset is silver. At the time they write the contract, the spot price for silver is roughly $15 per ounce. Brad obtains the right (but not the obligation) to sell his counterparty a specified quantity of silver at a strike price of $10 per ounce, significantly below the current market price. However, because it is a Russian option, there is no fixed maturity date for the option contract, and Brad can elect to exercise the put option at any time and sell the silver to his counterparty at any price that occurred during the life of the contract.
In exchange for this flexibility, Brad is required to pay his counterparty a significant premium, so much so that even with the generous terms of the option contract, Brad is far from certain that he will make money on the transaction.