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 exercisethe Lookbacks Options.

LookBack Options - Introduction

Before the invention of Lookback Options in 1979 by the co-creator of the popular Black-ScholesMerton 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!

Asian Option
Asian option (also known as average price option) is an option whose payoff is determined with
respect to the (arithmetic or geometric) average price of the underlying asset over the term of the
option.
While the payoff of a standard (American and European) option depends on the price of the underlying
asset at a specific point of time i.e. the exercise date, the payoff of an Asian option depends on the
average price of the underlying asset that prevailed over a period of time i.e. the term of the option.
There are two types of Asian options with respect to the method of averaging: in arithmetic Asian
option, the arithmetic average of the price of the underlying is used in payoff calculations; while in
geometric Asian options, geometric average is used.
Asian options have relatively low volatility due to the averaging mechanism. They are used by traders
who are exposed to the underlying asset over a period of time such as consumers and suppliers of
commodities, etc.

Formula
Following are simplified payoff formulas for four different variants of Asian option:
Arithmetic Asian Call Option Payoff
= max [0, arithmetic average of underlying's price exercise price]
Geometric Asian Call Option Payoff
= max [0, geometric average of underlying's price exercise price]
Arithmetic Asian Put Option Payoff
= max [0, exercise price arithmetic average of underlying's price]
Geometric Asian Put Option Payoff
= max [0, exercise price geometric average of underlying's price]

Examples
Example 1: Arithmetic Asian call option
On 1 January 20Y3, a trader purchased a 90 day arithmetic call option on AOL, Inc. The option has an
exercise price of $35 and the payoff is based on arithmetic average price of the underlying stock
determined after the end of each 30 day period. The stock price of the underlying asset at 30th, 60th
and 90th day of the option was $30.65, $36.9 and $38.49.
Arithmetic Asian call option payoff = max [0, ($30.65+$36.9+$38.49)/3 $35] = $0.35
Payoff of geometric Asian call option can be calculated by substituting the arithmetic average price of
the underlying asset with its geometric equivalent.
Example 2: Geometric Asian put option

Refer to data in Example 1 above, but assume that another trader bought a geometric put option with
the same exercise price i.e. $35
Geometric price of the underlying financial asset
= (30.65 36.9 38.49)1/3
= $35.81
Geometric Asian put option payoff = max [0, $35 $35.81] = 0
The put option is out of the money because the geometric average of the underlying price is higher
than the exercise price

What is a 'Knock-Out Option'

A knock-out option is an option with a built-in mechanism to expire worthless if a
specified price level is exceeded. A knock-out option sets a cap to the level an option can
reach in the holder's favor. As knock-out options limit the profit potential for the option buyer,
they can be purchased for a smaller premium than an equivalent option without a knock-out
stipulation.

BREAKING DOWN 'Knock-Out Option'

A knock-out option is a type of barrier option and may be traded on the over-the-counter
market. Barrier options are typically classified as either knock-out or knock-in. A knock-out
option ceases to exist if the underlying asset reaches a certain predetermined barrier during
its life. Contrary to a knock-out option, a knock-in option only comes into existence if the
underlying asset reaches a predetermined barrier price.
For example, an option writer may write a call option on a $40 stock, with a strike price of
$50 and a knock out level of $60. This option only allows the option holder to profit up to
$60, at which point the option expires worthless, limiting the loss potential for the option
writer. Knock-out options are considered to be exotic options, and they are primarily used
for commoditiesand currency options

What is a 'Knock-In Option'

A knock-in option is a latent option contract that begins to function as a normal option
("knocks in") only once a certain price level is reached before expiration. Knock-in options
are a type of barrier option that may be either down-and-in option or an up-and-in option. A

barrier option is a type of contract in which the payoff depends on the underlying security's
price and whether it hits a certain price within a specified period.

BREAKING DOWN 'Knock-In Option'

There are two main types of barrier option: knock-in and knock-out options. Technically, a
knock-in option is a type of contract that is not an option until a certain price is met, so if the
price is never reached it is as if the contract never existed. However, if the underlying asset
reaches a specified barrier, the knock-in option comes into existence. The difference
between a knock-in and knock-out option is that a knock-in option comes into existence only
when the underlying security reaches a barrier, while a knock-out option ceases to exist
when the underlying security reaches a barrier.

Down-and-In Option
For example, assume an investor purchases a down-and-in put option contract with a
barrier price of $90 and a strike price of $100, when the underlying security was trading at
$110, with three months until expiration. If the price of the underlying security reaches $90,
the option comes into existence and becomes a vanilla option with a strike price of $100.
Thereafter, the holder of the option has the right to sell the underlying asset at the strike
price of $100. The put option remains active until the expiration date, even if the underlying
security rebounds from $90. However, if the underlying asset does not fall below the barrier
price at any point during the life of the contract, the down-and-in option expires worthless.

Up-and-In Option
Contrary to a down-and-in option, an up-and-in option comes into existence only if the
barrier is reached, which is higher than the underlying asset's price. For example, assume a
trader purchases a one-month up-and-in call option on an underlying asset when it was
trading at $40 per share. The up-and-in call option contract has a strike price of $50 and a
barrier of $55. If the underlying asset did not reach $55 at any point during the life of the
option contract, it would expire worthless. However, if the underlying asset rose to $55 or
greater, the call option would come into existence.