LookBack Options by www.OptionTradingpedia.com

What are Lookback Options in Options Trading?

LookBack Options - Definition

LookBack Options, also known as Hindsight Options or Mocatta Options, are exotic options which allows the holder to "Look Back" at the price action of the underlying asset during expiration to decide the optimal price at which to exercise the Lookbacks Options.

LookBack Options - Introduction

Before the invention of Lookback Options in 1979 by the co-creator of the popular Black-Scholes-Merton Option Pricing Model, Nobel Laureate Robert C. Merton, there was no way investors can deal with one problem all investors face; Regret. Regret selling too early and regret holding on for too long to be suddenly swept by a correction. Lookback Options act as an insurance against regret as Lookback call options would allow investors to buy at the lowest price during the life of the options while Lookback put options would allow investors to sell at the highest price. With Lookback Options, investors would never again face the gruelling decision of timing an entry or exit!

LookBack Options - An Illustration

To illustrate the anti-regret properties of LookBack Options, consider the following scenarios:

1. Ordinary Call Options
You bought ordinary call options at $100 strike price on an underlying asset when it was trading at $100. The underlying asset rallies powerfully over the next few days to $150! You were overwhelmed and decided to risk holding on for more profits. However, the underlying asset drops just as fast over the next few days to $80 upon expiration of your $100 strike price call options. You lose all your money on those ordinary call options and totally regrets your decision to hold on when it was trading at $150.

2. LookBack Call Options
You bought LookBack Call Options on that same underlying asset when it was trading at $100. The underlying asset rallies to $150 and drops to $80 as before. Instead of regretting your decision to hold on, you simply exercise the LookBack Call Options at the highest price of $150 and profits the difference of $50! No regrets!

LookBack Options - 2 Types

There are 2 types of LookBack Options; Fixed Strike LookBack Options and Floating Strike LookBack Options.

LookBack Options - Fixed Strike LookBack Options
Fixed Strike LookBack Options pays off in profit the difference between the most favorable price and a fixed strike price.

Fixed Strike LookBack Call Options Example:
John buys Fixed Strike LookBack Call Options with a strike price of $100 when the underlying asset is trading at $100. The underlying asset falls to $70 immediately before rallying to $120 in a few days. John decides to hold on to see if the underlying asset would rally further. He was wrong and the underlying asset ditches to $80 upon expiration of the Fixed Strike LookBack Call Options. Instead of regretting his decision to hold on, John simply exercise the Fixed Strike LookBack Call Options at the peak price of $120 and pockets the difference of $20 as profit.

Fixed Strike LookBack Options are settled only in cash, so there is no way you can exercise the option in order to purchase the underlying asset at the most favorable price.

Disadvantage Of Fixed Strike LookBack Options
Option traders faces 2 problems; 1. How to enter a position at the lowest price, 2. How to exit a position at the highest price. Problem number 1 is known as the Market Entry Problem and problem number 2 is known as the Market Exit Problem.

From the above example, Fixed Strike LookBack Options solves the market exit problem completely. Through buying Fixed Strike LookBack Options, one would never have to decide the best time to sell one's position in order to lock in maximum profit as Fixed Strike LookBack Options allow one to always be able to sell at the most favorable price. However, what Fixed Strike LookBack Options do not solve is the market entry problem. Fixed Strike LookBack Options takes the fixed strike price as basis for profit calculation against the most favorable price eventually but what if the strike price isn't the lowest price you can enter the position at? What if the underlying asset in the above example drops to $50 before rallying to $120? Wouldn't an entry at $50 maximize profits instead? That is the exact solution that Floating Strike LookBack Options offer.

LookBack Options - Floating Strike LookBack Options
Floating Strike LookBack Options are much more expensive than Fixed Strike LookBack Options, and rightfully so for the market entry and exit solution it offers. On top of the privilege of exercising at the most favorable price upon expiration, Floating Strike LookBack Options uses not a fixed basis price against the most favorable price in profit calculations but the WIDEST price difference attained during the life of the options!

Floating Strike LookBack Call Options Example:
John buys Floating Strike LookBack Call Options when the underlying asset is trading at $100. The underlying asset falls to $70 immediately before rallying to $120 in a few days. John decides to hold on to see if the underlying asset would rally further. He was wrong and the underlying asset ditches to $80 upon expiration of the Fixed Strike LookBack Call Options. John exercises the Floating Strike LookBack Call Options at the peak price of $120 with the lowest price of $70 as the strike price, pocketing $50 as profit.

In the above example, it is clear that John need not time the entry of his purchase at all. Floating Strike LookBack Options completely eliminated the need to time his entry and exit! On top of that, Floating Strike LookBack Options allow the holder to buy the underlying asset at the lowest price attained during the price of the options instead of cash settlement. This is a useful feature when the underlying asset is trading at its highest point at expiration of the Floating Strike LookBack Call Options and is expected to trade higher.

LookBack Options - LookBack Call Options & LookBack Put Options

The above examples covers what Lookback Call Options are all about. LookBack Put Options perform the same function and are used to speculate a drop in the underlying asset.

Floating Strike LookBack Put Options Example:
John buys Floating Strike LookBack Put Options when the underlying asset is trading at $100. The underlying asset rises to $120 immediately before dropping to $80 in a few days. John decides to hold on to see if the underlying asset would drop further. He was wrong and the underlying asset rallies to $150 upon expiration of the Fixed Strike LookBack Put Options. John exercises the Floating Strike LookBack Put Options as if they were bought at a strike price of $150 and exercised at the lowest price of $80, making the difference of $70 in profit.

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LookBack Options - Where Is It Traded?

LookBack Options continue to be without standardized specifications nor pricing methods today (2007). That is why LookBack Options are traded only in OTC markets, which is not easily accessible to the general public through the various stock & options exchanges.

LookBack Options - European & American Style

Like plain vanilla options, LookBack Options have both European style, which allows the holder to exercise the LookBack Options only during expiration, and American style, which allows the holder to exercise the LookBack Options anytime before expiration.

LookBack Options - Pricing

Pricing of LookBack Options isn't standardized yet at the time of this writing (2007). The pricing problem of LookBack Options as well as exotic options continues to be a problem that keeps the academia very busy. Many methods have been suggested, ranging from the use of the classical Black-Scholes Model to more complex means like the Binomial Model and the Forward Shooting Grid method. Right now, until LookBack Options can be properly and fairly priced, we cannot expect it to be traded in the exchanges.

Even though a standardized pricing of LookBack Options are not yet agreed upon, it is generally understood that the more volatile the underlying asset, the more expensive LookBack Options will be. Floating Strike LookBack Options would also be generally more expensive than Fixed Strike LookBack Options due to the higher profit potential. Any LookBack Options would also be about twice as expensive as plain vanilla options due to the advantages they confer.

Advantages of LookBack Options

1. Completely eliminates market entry and exit timing problems.

2. Completely maximizes profits within the life of the options.

Disadvantages of LookBack Options

1. Expensive.

2. Not publicly traded.

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