Overview of Lookback Options

Lookback options are exotic contracts that offer the holder the advantage of being able to exercise at an optimal point. Essentially, at expiration the holder can look back (hence the name) at how the price of the underlying asset has performed and maximize their  profits by taking advantage of the biggest price differential between the strike price and the price of the underlying asset.

For options traders this is obviously a major benefit, as lookback options can be used to solve one of the biggest problems they face: market timing. This is basically choosing when to enter a position and when to exit it, with the aim obviously being to time entry and exit to make the largest possible returns.

Because of the way lookback options work, the issue of market timing becomes less important as profits are effectively guaranteed to be maximized. Also, the chances of a contract of this type expiring worthless are much lower than other types of options. For these reasons lookbacks are generally more expensive, so the advantages do come at a cost.

Lookbacks can be either calls or puts, so it's possible to speculate on either the price of the underlying security going up in value or going down. They are also known as hindsight options, as they actually give the holder the benefit of hindsight when determining when to exercise.

To fully understand how they work, you need to be aware of the two different types of lookback options – fixed strike and floating strike. Although the concept of these two types is very similar, and both offer the potential for maximizing returns.  There is a fundamental difference between the two and the way they work. On this page we have explained both types in more detail.

Fixed Strike

Fixed strike lookback options, as the name suggests, have a fixed strike price like most other options contracts. The advantage is in the fact that, at the time of expiration, the holder of fixed strike contracts can choose to exercise them at the point during the term of the contract where the underlying asset was at the most favorable point.

These are cash settled options, meaning the holder is paid a cash settlement equal to the profits they could have made through exercising and buying or selling the underlying asset. To make things clearer, we have provided a couple of examples below.

Example 1 of a Fixed Strike Contract

  • Call Option
  • European Style
  • Cash Settled
  • Based on stock in Company X
  • Company X stock currently trading at $50
  • Strike price of $50
  • Company X stock rises to $60 during term of contract
  • Company X stock falls back to $50 by expiration date

If you owned a standard call with the above characteristics, then your contract would expire worthless as there was no profit to be made at the point of expiration. The strike price is equal to the underlying security (stock in Company X), making it an at the money contract and there would be no financial gain in exercising.

However, with a fixed strike lookback contact, you would be able to effectively exercise at the optimal point when the stock was trading at $10 above the strike price. In practice, the contract would be automatically settled at expiration, assuming the contract had been in the money at some point. It's a cash settled contract, so you would receive $10 per contract owned based on theoretically being able to buy the stock at the strike price of $50 and sell it at the point it was trading at $60.

Example 2 of a Fixed Strike Contract

  • Put Option
  • European Style
  • Cash Settled
  • Based on stock in Company X
  • Company X stock currently trading at $50
  • Strike price of $50
  • Company X stock falls to $40 during term of contract
  • Company X stock rallies to $45 by expiration date

If you owned standard put contracts based on the characteristics above, then you would receive a $5 cash settlement at the point of expiration for each contract owned. This is based on the fact that the stock is $5 below the strike price, and the put gives you the right to sell at the strike price. However, with a fixed strike lookback contract, it would settle at $10 per contract owned, based on the optimum point when the stock was trading at $40, $10 lower than the strike price.

Floating Strike

The floating strike lookback option is different to the fixed strike in the way that the name suggests; the strike price is not fixed at the time that the contract  written. Instead, the strike price is automatically set at the lowest price of the underlying security during the life of the contract if the call or at the highest price of the underlying security if a put. Again, we have provided a couple of examples to illustrate how these work.

Example 1 of a Floating Strike Contract

  • Call Option
  • European Style
  • Cash Settled
  • Based on stock in Company X
  • Company X stock currently trading at $70
  • Strike price determined at expiration date
  • Company X stock falls to $60 during term of contract
  • Company X stock rallies up to $80 by expiration date

If you owned floating strike lookback options contracts as specified above, then you would receive a cash settlement of $20 per contract owned at the time of expiration. The floating strike price is set at the lowest price the underlying stock reached during the term, $60, and compared to the price of the stock at expiration date, $80.

This difference of $20 represents the profit to be made and, as the contracts are cash settled, that is the amount of the pay-out. Floating strike lookback options can also be physically settled, meaning you would be able to buy the stock at $60 rather than receiving a cash settlement. You could then choose to sell the stock immediately and take your profit, or hold on to the stock if you felt it would continue to increase in price.

Example 2 of a Floating Strike Contract

  • Put Option
  • European Style
  • Cash Settled
  • Based on stock in Company X
  • Company X stock currently trading at $70
  • Strike price determined at expiration date
  • Company X stock rises to $90 during term of contract
  • Company X stock drops back to $80 by expiration date

If you owned the contracts detailed above, then you would receive a cash settlement of a $10 per contract owned. Even though it is a put, meaning you have expected the underlying stock to fall, you have still made money despite the stock being priced higher than when you bought the contracts. This is because the strike price is set at the highest price the stock reached during the term of the contract - $90 in this case. As the stock has dropped back down to $80 by the time of expiration, the option settles at the difference between these two figures - $10.

Buying & Selling Lookback Options

Lookback options are not exchange traded products that are easily accessible on the various exchanges around the world, but are actually bought and sold over the counter (OTC). It's still possible to buy them using a broker, but you would need to use one that specifically deals with OTC products. For a list of suitable online options brokers, please visit our page on Best Brokers for OTC Options.