Here is the Lookback option enter the picture. Also known as a Review optionThe lookback reduces the timing uncertainties. In return, the lookback is more expensive than the standard option contract.
These contracts are bought over the counter (OTC) and not on one of the commonly used exchanges. Once the option has been bought or sold, the trader can review the underlying price over the life of the option and exercise it based on the best available price of the underlying asset. It makes sense to trade at the widest price between the strike and the underlying price.
Lookbacks are settled in cash when executed. A buyer receives cash based on the cheapest price level of the underlying asset over the life of the option. Sellers pay the lowest possible settlement price on the same basis. When a profit is made, the trader profits; In the event of a loss, the dealer pays the difference.
Lookbacks come in two forms: fixed and floating. With a fixed beat, the beat itself is set and cannot be changed. This is just like most of the standard options. The main difference, however, is that the trader can choose the most profitable underlying price during the time the option was open (or choose the lowest possible net loss). Settlement is based on this price selection and not on the most commonly used current strike and the underlying price.
In the case of a floating strike, the strike is set at the time of expiry on the most advantageous underlying price that will be achieved during the term of the option. A lookback call would be set to the lowest underlying price and a lookback to the highest underlying price. Settlement then takes place against the current market price against the floating strike.
A firm review solves the problem of when to leave the market. and a floating lookback solves the problem of when to enter. This allows a trader to better manage timing on one side or the other. As anyone can imagine, traders are expected to pay a higher price for options that provide these benefits than a non-exotic call or put based on the traditional action of the strike and the underlying price.
For example, an underlying stock is currently trading at $ 25, and that price exists both at the beginning and at the end of an option’s term. During that time, the highest price was $ 30 per share and the lowest was $ 20. With a fixed strike lookback option, the strike price is set at $ 25. The best price available was $ 30. Net income is $ 5 per share: $ 30 – $ 25 = $ 5.
With a floating strike lookback, the lowest price was $ 20 and the maturity was $ 25. The holder’s profit is also $ 5: $ 25 – $ 20 = $ 5. The profit for each version is identical as the base value has moved the same number of points above and below the strike during the holding period.
Example: Assuming different results, the stock had the same high of $ 30 per share and the same low of $ 40. However, the closing price was $ 27.50, net income of $ 2.50. In a fixed strike lookback, the highest price was $ 30 and the strike was $ 25. The profit was $ 5: $ 30 – $ 25 = $ 5. But with a pending review, the strike on maturity was $ 27.50. The lowest price during the period was $ 20 so the profit was $ 7.50: $ 27.50 – $ 20 = $ 7.50.
By adjusting the assumed opening, closing, highest and lowest prices, it is possible to calculate what the result will be. If the lookback never moves in the money on the call or put, the result would be a net loss. However, due to the lookback function, this loss is set to the lowest possible level. In both cases (profit or loss) the result is the optimum that can be realized.
With maximized gains or minimized losses, the chronic problem of timing for either entry or exit is resolved. A trader can choose a fixed or variable contract based on the cost of each premium as well as whether getting in or out is seen as the bigger problem. It also significantly reduces the likelihood of worthless expiration for a long option, which further explains why lookbacks are more expensive than other options contracts. A merchant pays for the more secure representations that come with a lookback contract.
The lookback is described as Path dependent because the result (profit or loss) is determined not only by the direction of the underlying price movement, but also by the extent of this movement. The all-too-common realization by traders that their timing was poor is resolved by looking back. This explains the motivation for trading the lookback. It offers some form of assurance that profit or loss is optimal, but it remains uncertain whether fixed or variable will be better in each case. The retailer has to decide individually what makes more sense. This decision often depends largely on the characteristics of the subordinate – their historical volatility, their long-term price range, and the rate of change in prices. While this selection describes all of the options, the lookback allows traders to reduce the market timing uncertainties for which they pay for the insurance lookbacks.
One of the most chronic problems traders face is deciding when to get out. If too early, additional gains may be overlooked; If it’s too late, earlier paper wins can evaporate. Looking back, these problems are completely eliminated. It can be seen as a kind of “remorse insurance”. Every trader understands the feeling of remorse that comes from poor timing all too well.
A premium is payable for this service. The typical lookback option can cost up to twice as much as a typical European style contract. Nonetheless, the fixed lookback offers an additional benefit. If the underlying reaches a new high (for a call) or a new low (for a put) since the date the option was entered, a payout is blocked for the option. This is the minimum that the treader will realize. It can be higher if the underlying price continues to rise (for the call) or fall (for the put). Higher volatility is beneficial to the trader as it leads to greater variability in the underlying price.
Michael C. Thomsett is a widely published author with over 80 business and investment books, including the best-selling Get started with options coming in its 10th edition later this year. He also wrote the recently published The math of options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as Seeking Alpha, LinkedIn, Twitter and Facebook.
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