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How to Invest in Rainbow Options 

Research shows that rainbow options are among the best investment vehicles because they are cost-effective, highly diversified, and can hedge against uncorrelated assets. In this post, you’ll get in-depth information about rainbow options. Always seek the advice of your accountant, financial advisor, or banker before trading derivative securities.

What is a rainbow option?

A rainbow option refers to a contract whose payoff is based on more than one risky underlying security. Just like many colors of a rainbow, this option similarly deals with many assets.

A rainbow option gets its value from more than one asset. Therefore, it is crucial to bear in mind that an investor benefits from this option when the prices of the underlying assets move in the anticipated direction, resulting in a profitable transaction.

Before we delve into rainbow options, we need to familiarize ourselves with two basic terms regarding stock options – a call and put options.

A call option is an agreement that accords the investor the right to buy an asset at a specific price on or before maturity. The seller of a call option is entitled to dispose of the security once the buyer decides to exercise their right.

The following example will help you have a hang of this term: suppose you buy a February 70 option on Citigroup share. This implies that you have the right to buy Citigroup shares at $70 each between now and February. Moreover, the call option seller must sell you a particular number of shares of Citigroup at $70 per share.

Before the call option is effected, the buyer and the seller have to agree on several issues – the nature of the underlying stock, the expiry date of the option, and the security price.

On the other hand, a put option is the right to dispose of an asset at a specific price on a particular period. 

I trust that now you understand the meaning of the term ‘option.’ Let us now proceed with our topic of discussion – the rainbow options.

How a Rainbow Option Works

Rainbow options encompass several underlying assets, and it accords the investor an opportunity to exchange one security for another at a strike price on or before the set date. The bearer of the option makes money when the value of all the underlying securities moves in the right direction. 

Therefore, as an investor, when you anticipate that many underlying assets will move in a particular direction, you will invest in either a call or a put option. Then, in case the underlying assets move in your desired course, you will exercise your option to realize profits. 

3 Little-Known Benefits of Rainbow Options

Investing in rainbow options can accord you immense benefits, as highlighted below.

Hedging against correlated assets

Rainbow options are crucial in hedging risks involving several assets. However, this approach is only useful in hedging negatively correlated assets (assets whose prices/values move in different directions). For instance, if securities C and D are negatively correlated, and the former is worse than the latter, a put-on asset C cushions you against price changes on either side.

Efficient cost

Investing in multiple assets is cheaper than putting your money in a similar sum of individual options. With rainbow options, you are likely to get discounts than when transacting in options that deal with individual assets.

Diversification of risks

Rainbow options deal with a variety of assets from different sectors with different risk exposure. For example, if you buy this option, it implies that you have diversified your investment by dealing with bonds, stocks, and currency. 

5 Different Styles of Options

The following is a highlight of various types of option styles.All option styles have varied tax treatment, complicating tax matters. We advice-seeking counsel before completing your tax return

The American option

Under this style, the option holder has a right to transact in the underlying security at a strike price on or before the expiry date. With this kind of arrangement, investors find this option attractive because they are guaranteed the freedom to exercise rights at any time within the contract period.

The American option can further be categorized into weekly and monthly options. For the former, the last day of exercising is on Friday, and the latter is executed on the third Friday of the month. 

With the American option, when the stock price moves up, you can sell your shares at a profit. Also, you can stand a chance of getting dividends if you exercise it before the dividend date. 

The European option

With the European option, you are restricted from exercising it until the expiration date. The downside of this option is that you can neither buy nor sell the underlying security, even if it has moved at price until the maturity date. 

It is essential to note that stocks are offered either in the American version or the European version, but not in both.

Bermudan option

This option is explicitly exercised on designated dates on or before the expiry of the contract. These options are executed at preset prices once a month. It is essential to note that their premiums are lower than those of the American options. The premium is the purchase cost, based on the price of an asset or the maturity date.

Barriers options

This option is only exercised when the price of an underlying asset passes a specific barrier. Barrier options are further classified into ‘in’ and ‘out’ options. The in options start on a low note but become active when a particular barrier is reached. However, the out options start actively but become useless once a barrier is arrived at.

Exotic options

An exotic/foreign option is usually meant for institutional investors, and it is a modification of the American and European styles of options. It is vital to note that foreign/exotic options are different from traditional strike prices, expiry dates, and payment structures. Exotic options can be exercised in either the American or European style; however, they differ in calculating their payoffs.

Pricing of Rainbow Options

As an investor, it is vital to note that the pricing of options is not done arbitrary but through a scientific and standardized model, such as the Black-Scholes method.

Trading on Rainbow Options

Trading in rainbow options is more comfortable and convenient. If you want to buy or sell an option, you can do it by either visiting the stock broker’s office or transact online. Before you make any transaction, it crucial to research the terms involved in the transactions to make an informed choice.

Final Thoughts

Rainbow options refer to a contract whose payoff is based on more than one risky underlying security. As an investor, it is advisable to transact in these options because they are diversified and more profitable. However, the tax profile of these investments is highly complicated with expert assistance advised for such investments.