The Lookback Option: Going Back to Greener Pastures

A lookback option is a highly sophisticated and unique type of options purchase that allows an investor to select a call or put price based on a wide range of trading values over the life of the option. Essentially, the investor can exercise the option at any point and use a trading price of his or her choice that occurred during the life of the option. This eliminates the possibility of "holding out too long" and losing potential profits.

Traditional Options Model

With a traditional option, an individual investor has the right to put or call an option at any point during its lifetime or upon its maturity date. The goal is to profit by anticipating the movement of the security. For example, in a call option, an investor purchases the right to take control of a stock at its current price. However, the investor does not do so immediately; he or she waits until a certain point in the future. If the price of the security goes up, the investor will exercise the call, purchasing the security at the previously low price and selling it at the higher, current price.

Lookback Options Model

The main flaw with an option is the possibility an investor may wait too long to exercise the call and miss out on valuable profit; or in the case of a put option, he or she may wait too long to sell. By missing the best window of time, the investor may even fall into a loss situation. A lookback gives the individual the right to exercise the option today for a price that occurred in a wide range of time. For example, if the investor waited too long to call an option, the security may be priced $50 more per share today than it was 6 months ago. If the lookback option was alive six months ago, the investor could simply opt for that earlier price.

Fixed Lookback

The key element of a lookback option is the initial price point used for comparison. In a fixed lookback, that initial price point is the value of the security determined the day the option is purchased. For example, imagine the fixed price of a security is $100 at the time the option is purchased. The investor watches the security fall to a price of $140 but fails to act on time. The security falls to $75. Exercising the call today would be ineffective, and the investor would lose $25 per share. However, with a lookback, the investor could exercise the call at the prior price of $140, minus the fixed price of $100, profiting $40 per share.

Floating Lookback

A floating lookback does not have a fixed price. Instead, the investor can select any price along the range of the option as the fixed price at the time he or she exercises the option. In the above example, the investor could choose to exercise the call at $140 and use the floating price of $75, profiting $65 per share. This option obviously creates a tremendous amount of flexibility, but the investor will pay high transaction costs, cutting into some of the profit.

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