Rainbow Option

  

Categories: Derivatives

A rainbow. A collection of colors. Not just a room painted all drab brown, or an ugly shade of pea green. A vibrant, eclectic collage of colors.

Now let’s take that concept to the options market.

A vanilla option can be considered the drab-brown or pea-green paint equivalents in the derivatives market. This category includes regular calls and puts, options to buy or sell a single underlying asset (like a stock or commodity).

Just as a rainbow contains many colors, a rainbow option contains many underlying assets. It's a complex option contract based on the performance of multiple assets (based on several stocks, or a basket of commodities).

Rainbow options come in multiple varieties. Some pay off only based on the best performer in the group. Others are based on the minimum performance of all the option's component "colors." The main point is that they apply to multiple underlying assets at once.

Related or Semi-related Video

Finance: What Is a Call Option?25 Views

00:00

finance a la shmoop. what is a call option? option? option, where are you? okay

00:09

yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]

00:14

is the right to call or buy a security. the concept is easy the math is hard.

00:24

you think Coca Cola's poised for a breakout as they go into the new low

00:30

calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]

00:35

call option for $1. well that call option buys you the right

00:39

to then buy coke stock at 55 bucks a share anytime you want in the next

00:44

hundred and 20 days. so let's say Coke announces its new sugarless drink flavor

00:48

zero it's two weeks later and the stock skyrockets to fifty eight dollars a

00:53

share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]

00:59

so you buy the stock and you're all in now for fifty five dollars plus one or

01:04

fifty six bucks a share and your total value is now fifty eight bucks. well you

01:10

could turn around today and sell the bundle that moment, and you'll have

01:13

turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]

01:18

stock not skyrocketed so quickly well you would have lost everything. still you

01:23

lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]

01:27

options. as for Coke flavor zero turned out to be nothing more than canned water.

Up Next

Finance: What Is a Put Option?
83 Views

What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...

Finance: What is a Derivative?
23 Views

A derivative of a security is a "something" which derives its value based on the performance of that security... either a put option or a call option.

Find other enlightening terms in Shmoop Finance Genius Bar(f)