Lookback Option

Understanding Lookback Option in Trading

When engaging in trading, you are likely to encounter several types of options. One such option is the Lookback Option. This terminology might seem daunting at first, especially for trading beginners. However, we will simplify it for you as much as we can.

What is a Lookback Option?

A Lookback Option is a type of advanced, exotic option that lets you look back in time to determine the worth of the option. It allows you, as an investor, to 'look back' over time to see the highest value or lowest that the asset reached, to calculate the payoff. This flexibility provides you with the security of gaining the maximum return possible from the underlying asset.

Types of Lookback Options

Lookback Options come in two types: fixed and floating. A fixed Lookback Option allows investors to use the highest high or lowest low as the strike price. On the other hand, a floating Lookback Option enables them to use the asset's value at the expiration as the strike price. This difference in the handling of the strike price is the key differentiation between these two types.

Benefits of Lookback Options

If you opt to choose a Lookback Option, you gain the ability to maximize your profit while limiting your loss. Thanks to its feature that lets you 'look back' at the highest and lowest values the asset achieved, you can 'lock-in' the most favorable buying/selling price that had occurred. Furthermore, Lookback Options also offer protection against market volatility, as the price at the expiry time becomes the focal point, limiting the risk.

Risks of Lookback Options

While Lookback Options present significant benefits, they also carry risks. The convenience and security they offer come at a high price. Their premiums are usually more expensive than standard options. Plus, their exotic nature makes them less liquid and more difficult to evaluate.

Conclusion

Now that you have a better understanding of a Lookback Option, you can make informed decisions when you encounter it in your trading journey. Like every other trading tool, this option has advantages and risks. Your task, as an investor, is to weigh these factors and decide if it aligns with your trading strategy.