Outperformance options are a type of exotic derivative that allows investors to make leveraged trades based on the relative performance of two assets. An outperformance option works by measuring the gains and losses of two assets, such as equities, bonds or currencies, over a set period of time and comparing their performance in relation to one another.
This guide is your outperformance options 101, with all the relevant information on pricing and strategy, as well as examples to help day traders get started with this exotic option.
Below we list the top-rated brokers that offer retail options trading in 2022.
Outperformance Options Basics
- Outperformance options compare the performance of two assets over a period of time
- The payoff is based on the difference, or spread, between the performances of the two assets
- A wide range of trading assets can be used, including equities, indexes, currencies or combinations
- Outperformance options are usually traded over the counter, though they can be found on some exchanges
- Investors use outperformance options for speculation and hedging purposes
How Outperformance Options Work
Outperformance options take two assets and pit them against each other over a period, with the investor earning money if they correctly predict which asset will outperform the other. As with other types of options, traders can adopt short positions with outperformance put options or long positions with call options.
The payoff is determined by the difference in performance between the two options, also known as the spread. In this respect, outperformance options bear a resemblance to another exotic derivative called a spread option, in which the payoff is determined by the difference in price between two assets. However, outperformance options refer to the relative performance of the two assets rather than the absolute price, so traders should be careful not to confuse the two.
The following example illustrates the meaning of “relative performance” in relation to outperformance options…
Imagine a trader at a hedge fund has a hunch that the smaller company A will have a good year of business compared to a larger rival, company B. He takes out an outperformance call option pitting equities from the two companies against one another.
At the start date of the contract, company A’s stocks trade at $1, while company B’s trade at $100. When the contract matures, company A’s stock has risen to $1.10, while company B now trades at $101. Company B’s stock has risen by a dollar – ten times more growth in absolute terms than company A. Yet company A has outperformed company B, since its share price increased by 10 percent over the period rather than company B’s 1 percent.
In this case, the investor’s option is in the money, since he correctly guessed that company A would outperform company B. The payoff will be determined by the difference in performance of the two companies over the period. If the investor had wrongly guessed that company B would outperform company A, he would not receive any payoff.
The payoff is calculated with a formula devised by finance scholar William Margrabe, and the term “Margrabe options” is synonymous with outperformance options.
Trading Outperformance Options
Though they can sometimes be traded on exchanges, outperformance options like other exotic derivatives are most often sold over the counter and cash-settled. The majority are European style, meaning they must be settled on their expiration date, though American style contracts, which can be exercised at any time up to expiration, are also available.
While over-the-counter outperformance options are usually only available to large firms and institutional investors, day traders may be able to access products through some exchanges. Good brokers can help traders make a list of which options are available on specific exchanges, and they may also provide quotes on pricing and guidance in other key areas before making a trade.
Outperformance Options Strategy
Outperformance options are flexible since they allow investors to measure the performance of diverse asset types against one another. A common trade might track the performance of two indexes, such as the Nasdaq and S&P 500. However, investors are not limited to comparing like for like, and could also use outperformance options to pit the performance of individual stocks or ETFs against an index, for example.
In this case, the product could be used to place a bet that a certain sector or company will outperform the rest of the market. For example, prior to the 2007 financial crisis, historical data had shown a correlation between tech and energy stocks and the rest of the S&P 500. But in 2009, Morgan Stanley advised investors to use outperformance options to bet that these two sectors would recover more quickly than the rest of the market. The performance of big tech companies in the USA over the last decade proved that with the right bet, outperformance options are a way to gain exposure to equities that can be more lucrative than simply trading stocks.
They are also used in hedging strategies by correlation traders, who seek to profit by making bets on the average correlation of stocks in a given market. In addition, they can be used for hedging purposes by an investor when they have exposure in an asset which carries more risk than a similar asset – for example, equity in a company from a foreign country with a volatile exchange rate.
As with any type of trade, the key to success lies in educating yourself through careful research. Since outperformance options evaluate the performance of two assets in relation to one another, studying the data can be complex. Traders should always be familiar with the relevant charts and tables before making a trade, and they are advised to check the historic data going. They should also read up on general market conditions and keep tabs on day-to-day finance news in the Wall Street Journal, for example, as this will help generate ideas on good candidates for trades. If you are trading on the New York Stock Exchange (NYSE), you will want to be up to date on all the important information related to that market.
Final Word On Trading Outperformance Options
Outperformance options can be a flexible and powerful addition to a trader’s arsenal – as long as that investor is adept at analyzing historical data, evaluating pricing, and initiating the best strategy for a given market. Since they can provide leveraged exposure, outperformance options can be a lucrative type of derivative for traders with an eye for correlation trading and a good sense of which asset types are set to perform well.
They can also provide hedging options for traders with exposure to correlation risk, or to those with an interest in a company that carries heightened risk compared to similar companies.
How Do Outperformance Options Work?
Outperformance options compare the relative, rather than the absolute performance of two chosen assets, and give the successful trader a payoff based on the spread between the two assets. They are usually cash-settled, European-style options which can only be exercised on the date of expiry, though other types of contracts are available.
Where Are Outperformance Options Available?
As with other types of exotic derivatives, outperformance options are most commonly traded over the counter, though they are also available on some exchanges.
Why Trade With Outperformance Options?
Outperformance options are an excellent choice for the speculative trader who sees the potential for a particular index, company, or another asset to outperform its peers. They can also be used for hedging purposes by traders with exposure to specific types of risk.
Where Can I Learn More About Outperformance Options?
A wealth of information is available online for traders eager to learn more about different types of options, and Daytrading.com is the ideal starting place. You can also check for finance content posted by experts on sites like YouTube, or enrol in a trading course for in-depth training.
What Are The Benefits Of Outperformance Options Vs Stocks?
As with other derivatives, outperformance options derive their value from an underlying asset without necessarily involving the purchase of the asset. In the case of options, losses are limited to the premium paid by the investor when buying the contract, as they have the right not to exercise any contract which is not profitable.