Rainbow Options

For those who want to hedge against a bit of extra uncertainty when investing, a rainbow option provides the perfect vehicle since its value is based on more than one underlying asset. They are a bit tricky to understand, but many investors use them to hedge risks that could arise from various events.

The Sports Analogy
Some investors like to use the sports analogy as the easiest ways to understand a rainbow option is to liken them to several games occurring simultaneously at the same sports complex. For example, at your son’s little league tournament there are four games all occurring at the same time but on different fields. If you bet on the outcome of all four games, you would need to be right on all games in order to win the bet. A rainbow option is similar in concept. Since there are more than two derivatives underlying the option then all derivatives need to move as the investor predicts they will in order to be profitable.

Hedging Against Events
Another way of looking at rainbow options would be when an investor wants to exchange oil futures for cotton futures. Geopolitical events in the Middle East settle down and as a result more oil is available for export. This drives the price per barrel of oil down but a recent cotton blight reduced the amount of cotton which drove the price up. Since the price of oil went down and the price of cotton went up the investor would have gained in hedging against this event.

Characteristics of Underlying Assets
Another aspect of rainbow options is the fact that the underlying assets don’t necessarily need to have the same characteristics. For instance, the expiry dates can be different as can be the strike price. This is one area that confuses investors who are new to rainbow options. However, even though the characteristics can be different, the investor needs to ‘predict’ the correct movement of each in order to be successful.

How Rainbow Options Differ from Simple Options
As evidenced by the above analogies, the amount of uncertainty is the main difference between a rainbow option and a simple option. In a simple option the investor is only exposed to uncertainty from one source which is in the underlying asset. Conversely, in a rainbow option the uncertainty is compounded by the number of underlying assets. An interesting fact here is in what these underlying assets are called. The number of assets is referred to as the number of colors in a rainbow.

Standard Strategies of Rainbow Options
Since rainbow options have more than two underlying assets, there are various ways to correlate those assets in order to ‘wager’ your investment. The most common strategies employed in rainbow options are worst-of option, better-of option, spread option, minimum option, maximum option and two asset correlation option. While there are other strategies utilized by rainbow option traders, these are definitely the most common strategies utilized. When using the minimum and maximum option together it is often referred to as a min-max and the worst-of option with the better-of option are often called alternative options.

The best way to view rainbow options is to think of them as the best way to hedge against several uncertainties in underlying assets. Also, the closer the underlying assets are correlated the less the option will cost and vice versa. If they are not even remotely correlated the option will necessarily cost more. Some investors find that rainbow options are the best way to hedge against a greater amount of uncertainty and as a result use this type of option when uncertainty is high.

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