Rainbow Options
Rainbow options are a type of exotic option that allows traders to speculate on multiple assets in a single trade. This investing guide will explain how rainbow options work and outline the pros and cons of this style of trading. Read on for an analysis of the key strategies for trading rainbow options, as well as important tips for getting started with this type of derivative.
Below we list the top-rated brokers that offer retail options trading in 2024.
Rainbow Options Explained
To define rainbow options simply: they are a style of options contract involving speculation on the performances of two or more underlying assets.
How Rainbow Options Trading Works
Rainbow options typically involve making multiple calls or puts on several assets. In doing so, traders consider a group of assets and can speculate on the best or worst performer within the group or the minimum performances of all the assets.
For example, if an investor makes a call rainbow option on the FTSE 100, Dow-AIG Commodity Futures Index and S&P 500, it will pay out the difference between the strike price and the level of the index that has performed the best, i.e. risen in price.
Rainbow options use a weighted average across the best or worst performing assets. The best version can earn investors significant profits, while the worst is normally low-cost to buy and sell.
Importantly, at expiry, the assets are organized by performance. For example, let’s take a rainbow call with weights of 50%, 30%, and 20%, which includes assets like an equity stock index, a bond index and a foreign currency. The contract will pay 50% of the best return (at expiry) between the equity stock index, the bond index and the foreign currency, 30% of the second best and 20% of the third-best return.
When trading rainbow options, the underlying assets can have different characteristics, for example, the strike price. However, all of the underlying assets must move in the predicted direction for the investor to receive a profit.
Payoff Scenarios
Rainbow options come in various forms depending on how the assets are considered in the contract. However, as long as the payoff is dependent on more than one asset, the option is considered a rainbow.
Trading scenarios include:
- Best of assets or cash option, delivering the maximum of two assets and cash at expiry
- Call on maximum option, giving the holder the right to purchase the maximum asset at the strike price at expiry
- Call on minimum option, giving the holder the right to purchase the minimum asset at the strike price at expiry
- Put on maximum option, giving the holder the right to sell the maximum of the underlying assets at the strike price at expiry
- Put on minimum option, giving the holder the right to sell the minimum of the underlying assets at the strike at expiry
- Put 2 and call 1, an exchange option to put a predefined asset and call the other asset. So, asset 1 is called and the “strike” is asset 2
History Of Rainbow Options
The term rainbow options was coined by financial engineer and economist Mark Rubinstein in 1991. In his work, Rubinstein uses a rainbow metaphor to describe the style of trading. He stated that just like a rainbow has multiple colors, a rainbow options contract has multiple assets.
Rubinstein categorizes rainbow options by their number of assets; a “two-color rainbow” is an option with two underlying assets, a “three-color rainbow” is an option based on three underlying assets, and so on.
Key Characteristics
Key features that distinguish rainbow options trading from other derivatives include:
- Multi-asset trading
- Traded over the counter (OTC)
- Several different strike prices and expiry times permitted
- Dependent on the individual performances of a group of assets
- Weighted averages attributed to the underlying assets which determine the payout structure
- Underlying assets can be denominated in a different currency to that of the rainbow options order
- Presented as structured notes for the retail and fashion sector, including a capital guarantee feature exclusive to rainbow options trading
- Can be used for correlation purposes to value a product based on more than one uncertainty, for example, natural resources deposits with price and quantity
Pros & Cons
Pros
- Customizable – Investors can choose whatever combination of assets they desire for each rainbow options trade
- Cost Efficiency – Trading rainbow options is often cheaper than trading the same assets with singular options contracts
- Weighted Averages – The averaging mechanism provides greater scope for price fluctuations compared to alternative contracts that require specific price speculations
- Risk Diversification – Trading enables access to several markets in one trade, meaning that investors can vary the risk level. For example, using forex and bond indices provide access to the bond and foreign exchange markets simultaneously
Cons
- Extra Fees – Due to their additional features, trading rainbow options can have extra fees
- High Risk – Rainbow options expose traders to a greater amount of uncertainty which subsequently multiplies the risk level
- Complex Analysis – By definition, rainbow options mean that investors have to juggle several moving parts which may be difficult for beginners
- Quanto Risk – If a rainbow option includes an asset denominated in another currency to the option itself, the rainbow’s value can be severely impacted
- Advanced Financial Product – Trading rainbow options requires skill and experience to execute profitably. For those wanting to switch from playing Minecraft to financial trading, rainbow options is not the best road to take
Strategies
Like any other type of trading, it is important to have an effective trading strategy. Sticking to a system helps traders to avoid acting on impulse, and organize their decisions and finances in a structured manner. However, rainbow options trading strategies can be complex, and each strategy will vary depending on your specific needs. Some strategies that traders may find useful include:
Hedging
Hedging is a common trading strategy used by all types of traders as well as large corporations. Specifically, delta hedging for rainbow options uses the options contract to minimize the risk of price fluctuations upon multiple underlying assets, and isolate any
volatility which may negatively impact the trader.
Simply put, this means that traders can buy or sell rainbow options to offset the risk of buying the equivalent amount of stock or shares, for example, elsewhere.
The “delta” represents a change in the value of an option due to the change in the market price of the underlying asset. This strategy is particularly useful with rainbow options as it gives traders access to multiple markets which enables them to reduce the risk on multiple fronts through just one contract.
Trends
Incorporating market analysis into your strategy will often lead to better returns. With this approach, traders analyze the markets where the underlying assets reside and use the data to inform their decisions.
Traders can also use the trends in barchart data as an indicator to make a call or put rainbow option. Keep in mind that when you are tracking several different assets, this can be a difficult line to follow.
Comparisons
As an exotic derivative, rainbow options trading does differ from vanilla options, which involve simple speculation on the future price of an underlying asset. By definition, trading rainbow options involves multiple assets, which offers investors the unique opportunity to speculate on multiple individual performances within a chosen group of assets.
Rainbow options share similarities with other exotic options that offer advanced features. For example, like barrier and range options, a certain threshold must be reached for the option to expire in the money. Specifically, correlation options (a type of rainbow option) follow an identical structure to barrier options. The only difference is that rainbow options involve more than one asset.
Rainbow options are most similar to basket options. Basket options are also multi-asset and similarly, the payoff is determined by the assets’ performance. However with basket options, the payoff depends on the collective performance of all the underlying securities as opposed to each individual asset’s performance.
Investors and retail traders often prefer rainbow options to other option types as they offer attractive multi-asset linked products, as well as the ability to benefit from a particular asset’s performance within a group of assets.
How To Start Trading Rainbow Options
Before you start trading, there are several actions you need to take:
Find A Broker
Open a brokerage account with a broker that facilitates rainbow options trading and accepts investors from your nation or city. Most online brokers accept international traders, so whether you live in Texas or Alabama in the USA, a city in India, Kuwait, Japan, the UAE, the UK or Zimbabwe, you should be able to find a supporting platform.
Ensure that your chosen broker is regulated and check for additional licenses. Any supplementary offering like educational resources also signals a reputable broker.
Trading Platform
Select a trading platform with an interface that meets your charting and analysis needs. It is usually best to select a straightforward terminal that is easy to navigate so that after login you can use the program easily and begin your rainbow options journey.
It is also worth considering what trading tools you might need for your strategy. The best platforms offer trading charts and bar charts, rich market data, as well making educational PDFs available for download.
Notably, TD Ameritrade’s exclusive trading platform “thinkorswim” offers a seamless trading platform that is easy to launch and make payments on.
Study The Market
It is important to have a good understanding of your chosen assets’ past performance before you enter a position. Analyzing each market’s signals, price falls and spikes will help you to make more informed decisions and improve your chances of earning a profit.
Practice Virtually
Before you start trading rainbow options with real capital, you could try simulating your potential trade. You can find several rainbow option profit calculators on the web which reveal if a trade will expire in or out of the money. Demo accounts are also a good place to develop and test potential strategies. Both NinjaTrader 8 and TradingView offer good practice accounts.
Final Word On Trading Rainbow Options
Rainbow options trading is a great way for investors to access multiple markets at once and speculate beyond an individual spot price. However, their risk and complexity make them best suited to experienced investors. Beginners may want to consider binary options instead.
Always ensure that you follow sensible money management practices, choose a reliable broker and don’t invest more than you are willing to lose.
FAQs
What Assets Can Be Traded With Rainbow Options?
Several underlying assets can be used when trading rainbow options, including stocks in a large company like Meta (formerly Facebook), Google or Starbucks, ETFs, NFTs and cryptos as well as commodities.
How Safe Is Trading With Rainbow Options?
First, make sure that you are using a regulated, reputable broker. Like other types of exotic options, trading rainbow options are high-risk and complex investments. Do your research before you start trading these complicated options. Useful resources include YouTube financial videos, Yahoo Finance and Reddit forums as well as financial news websites like MarketWatch. You can even test your trading knowledge with Quizlet cards.
What Differentiates Rainbow Options From Other Option Types?
The key difference when trading rainbow options is that investors speculate on the individual best and worst performers in a group of assets. The outcome of these options relates to multiple calls and puts rather than a single asset price.
How Are Rainbow Options Priced?
Any rainbow option’s pricing and valuation rely on the relevant industry-standard models such as Black-Scholes. Notably, some indicators and profit calculators use a JavaScript API that provides users access to different pricing models, for example, the IFP Monte Carlo Simulation Generator.
Can You Buy Rainbow Options On Exchanges?
Rainbow options are sold over the counter (OTC) and not on exchanges.