What Is a Lookback Option?
Let me explain what a lookback option is: it's an option that lets you, as the holder, exercise it at the most beneficial price the underlying asset reached over the entire life of the option.
Key Takeaways
- Lookback options are exotic options that allow a buyer to minimize regret.
- Lookback options are only available 'over-the-counter' (OTC) and not on any of the major exchanges.
- Lookback options are expensive to establish and the potential profits are often nullified by the costs.
- Fixed strike lookback option solves the market exit problem—the best time to get out, while the floating strike lookback option solves the market entry problem—the best time to get in.
Understanding Lookback Options
You might also hear them called hindsight options, and they give you the advantage of knowing the full price history when deciding when to exercise. This reduces the uncertainties around timing your market entry and lowers the risk that the option expires worthless. But remember, these benefits come at a cost—lookback options are expensive to set up.
As an exotic option, a lookback lets you 'look back' at the prices of the underlying asset throughout the option's life after you've bought it. You can then exercise based on the most beneficial price, taking advantage of the widest gap between the strike price and the asset's price. These don't trade on major exchanges; they're unlisted and handled over-the-counter (OTC).
Lookback options are cash-settled, meaning you get a cash payment at exercise based on the most advantageous difference between high and low prices during the period. Sellers price them near the widest expected price spread, based on historical volatility and demand, and you pay the cost upfront. The settlement equals what you could have profited from buying or selling the asset itself. If it's more than your initial cost, you profit; otherwise, you take a loss.
Fixed vs. Floating Lookback Options
With a fixed strike lookback option, the strike price is set at purchase, just like in most options. But when you exercise, you use the most beneficial price from the asset's history instead of the current market price. For a call, you can pick the highest price for the best return. For a put, you go with the lowest price to maximize gain. The contract settles against that past price and the fixed strike.
For a floating strike lookback option, the strike sets automatically at maturity to the most favorable price during the contract's life. Calls fix at the lowest asset price, puts at the highest. Then it settles against the current market price, calculating profit or loss from the floating strike. The fixed strike handles the market exit issue—the best time to get out. The floating strike deals with market entry—the best time to get in.
Examples of Lookback Options
Take this first example: suppose a stock starts and ends at $50 over a three-month option, with no net change. During that time, it hits a high of $60 and a low of $40. For a fixed strike lookback, the strike is $50, and the best price is $60, so profit for the call holder is $60 - 50 = $10. For a floating strike, the lowest is $40, maturity price is $50 as strike, profit is $50 - 40 = $10. Profits match because the stock moved equally up and down.
In a second example, same high of $60 and low of $40, but it closes at $55 for a $5 gain. Fixed strike: highest is $60, strike $50, profit $10. Floating strike: maturity sets at $55, lowest $40, profit $15.
Finally, if it closes at $45 for a $5 loss. Fixed strike: highest $60, strike $50, profit $10. Floating strike: maturity $45, lowest $40, profit $5.
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