Lookback Option - Explained
What is a Lookback Option?
Written by J. Mance Gordon
Updated at April 22nd, 2024
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What is a Lookback Option?
A lookback option is a type of option that gives the holder the opportunity of knowing its history when deciding on the appropriate time to exercise it. This option has a benefit of reducing the uncertainties arising when timing the market entry. It belongs to a category of exotic option possessing path dependency. Exotic options are classified as more complex than the vanilla options and are traded over the counter.
How Does a Lookback Option Work?
The strike price of the lookback option is floating, and it's determined at maturity. This strike price is derived from the optimal value of the price of the underlying asset during the lifespan of the option. It allows the holder to review the historical prices of the underlying asset over the life of the option.These types of options are unlisted and therefore do not trade on the formal exchanges. Upon their execution, the holder is awarded a cash settlement equivalent to the profits that would have been realized in the buying or selling of the underlying asset. They are two types of lookback options which are the fixed strike price and the floating strike price, and they are both present for the call and put options.A strike price is that at which exercising a derivative contract can be done and it mostly relates to stock and index options. The strike price in call options is that at which the buyer can purchase the security until the date of expiry. On the other hand, for put options, the strike price is best known as the price at which the option buyer can sell the shares.
Examples of Lookback Options
Assume that an option has a three-month contract and it trades at $100 at the beginning and end of the contract. At a certain point in the options period, it reaches a high price of $120 and a low price of $80.For a fixed strike lookback option, the best price reached is $120 while the strike price is $100. Based on these, the holder's profit can be calculated as follows: $120 - $100 = $20.For the floating strike option, the stock matures at $100 which is also the strike price. Since the lowest price is $80, the holder's profit will, therefore, be $100 - $80 = $20The reason these profits are similar is that during the option's lifespan, the stock shifted both higher and lower by the same amount.