Ladder Option - Explained
What is a Ladder Option?
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What is a Ladder Option?
A ladder option refers to an exotic option which looks in partial profit as soon as the underlying asset hits predetermined rungs or price levels. This assures at least some profit, irrespective of the underlying asset retracing beyond the rungs before the option expires. Ladder options are available in varieties of put and call. Don't mistake ladder options, that are specific forms of options contracts, for long put ladders, long call ladders, and their short counterparts. These counterparts are options strategies which involve the simultaneous purchase and sale of multiple contracts.
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How Does a Ladder Option Work?
A ladder option is similar to a traditional option contract which gives the holder the right, but not the obligation to either buy or sell an underlying asset at a pre-planned price or date. Nevertheless, ladder options ass a feature which permits the holder to secure partial profits at intervals that are predetermined. These intervals are referred to as "rungs" and the higher the number of rungs the underlying asset crosses, the more profit secures. The holder keeps profits on the basis of the highest rung attained for calls or the lowest rung attained for puts irrespective of the underlying's price crossing back below (for calls) or even above (for puts) the rungs before it expires. Because non-returnable partial profits are earned by the holder as the trade develops, the total risk is a lot lower as against traditional vanilla options. The compromise is that ladder options cost more than similar vanilla options.
Ladder Option Example
Consider a ladder call option with 50 as its underlying asset price, 55 as its strike price, rungs set at 60, 65, and 70. Supposing the underlying price gets to 62, the profit locks in at 5 (i.e. rung minus strike or 60-55). Supposing the underlying gets to 71, then the locked in profit rises to 15 (new rung minus strike or 70-55), irrespective of the underlying falling below these levels before the expiry date. As with vanilla options, the time value is also associated with ladder options. Hence, the traded price for call options is typically above the locked in the amount of profit, and declining as the expiry date approaches. If the underlying's price falls below any of the rungs triggered, again for calls, it practically doesn't matter to the option's price the partial profit is guaranteed. Even though this is oversimplified in that the lower the underlying goes beneath the highest triggered rung, the less likely it would be to bounce back to surpass the rung and get to the next rung.