In finance there is a special type of exotic options known as lookback options, which were invented in 1997 by Nobel Laureate Robert C. Merton. It allows the holder of such an option to “look back” over time and identify the payoff. Lookback options are used by investors to reduce uncertainties associated with the timing of market entry. Investors sometimes use lookback options for alternative investment management strategies. However, such investments are often considered as an expensive and quite speculative.
There are two kinds of lookback options:
- Fixed. Strike price of such an option is fixed at purchase. The payoff from a fixed lookback call option is the same as from the European call option however the final price is replaced by the maximum price which was achieved during the existence of the option. The payoff from a fixed lookback put option is the same as from the European put option while the final price is replaced by the minimum price which was achieved during the existence of such an option.
- Floating. Strike price of such an option is fixed at maturity. The payoff from a floating lookback put option is the amount by which the maximum asset price achieved during the existence of the option oversteps the final asset price. While the payoff from a floating lookback call option is the amount by which the minimum asset price achieved during the existence of the option oversteps the final asset price.
However, lookback options do not have standardized specifications and are traded only in OTC markets, which are not so easily available to the public through stock and options exchanges. For the investor who uses lookback options for alternative investment management strategies it helps to completely eliminate market entry - exit timing problems and maximize profits within the life of such an option.
