Summary:
When there is a significant increase in the strike price because the price of an underlying asset has reached a pre-decided threshold, it is known as a balloon option. This blog explains how balloon options work and how they are different from their namesake in the finance market.
Introduction to balloon option
When there is a significant increase in the strike price because the price of an underlying asset has reached a pre-decided threshold, it is known as a balloon option. The leverage that an investor has on an underlying asset increases with a balloon option. These are traded over the counter and mostly deal with scenarios where there is a high degree of volatility, including hedging of assets and trading in foreign currencies. If you are keen on understanding how balloon options work, this blog has exactly what you need.
How balloon options work
A type of exotic option, a balloon option is in most cases complex and is used for hedging against risks. Most often, the use of balloon options is taken into consideration when a currency is an underlying asset. The volatility of currency assets tends to be high.
The regular payout of an option increases when a threshold price is breached, which is why it is called a balloon option. These exotic options are traded over the counter and are usually less expensive than usual options. But they do have some points of distinction. It is difficult to get access to them without high-level portfolios and are used to address situations which are very specific.
Irrespective of whether up or down, businesses, traders and investors use balloon options to hedge certain moves in specific currencies and assets. These options are usually helpful for hedging against the movement of an asset in a given range because the option may not have a payout if its rise or fall is way beyond a fixed threshold.
Balloon options and barrier options:
For a balloon option, there is a strike price that keeps on moving along with the price of the underlying asset. This gives the holder the liberty to alter the strike price and set it to the spot price.
For a knock-in or knock-out option, barrier options need certain levels at which the underlying assets must be traded. In other words, it functions just like any other option, but is deemed worthless (knock-out) or pays out (knock-in) when a certain price barrier is reached.
In contrast to this, a balloon option continues to be active irrespective of the price of the underlying asset. However, when a threshold price is reached, the movement of the strike price takes place based on a ratio that is at a specific ratio in contrast to the price of the asset.
Barrier options and balloon options are both types of exotic options in the realm of financial derivatives. However, they both have their unique characteristics and purposes. The following are some of the key differences between balloon options and barrier options:
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Barrier options:
Barrier options, a type of exotic option, have a predetermined price level, which is known as the 'barrier'.
The two main types of barrier options are:
- Knock-in options: These options are rendered active ('knock in') only if the price of the underlying asset is able to reach or cross the barrier point during the lifetime of the option.
- Knock-out options: These options become deactivated ('knock out') only if the price of the underlying asset is able to reach or cross the level (barrier) during the option's lifetime.
Barrier options can be structured as both call and put options.
Barrier options are frequently used to reduce the premium cost of traditional options, or to take advantage of anticipated price movements near the barrier level.
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Balloon options:
Balloon options are rare and can be seen as a specialised type of barrier option. These options have different barrier levels that need to be crossed in order for the option to become active. Balloon options are usually used for complex risk management strategies and are customised to specific needs. They can be structured as call or put options and the threshold levels are set depending on the desired strategy.
Summing up
Those participating in trading markets often find themselves confusing balloon options with balloon payments. This is a type of loan that does not completely amortize over the lifecycle of the loan. When the term nears the end, a balloon payment is necessary to clear the principal balance of the loan. This is quite in contrast to that of the scenario for balloon options, which are complex financial tools to hedge against risks. With a little help from the right avenues and the details listed in this blog, navigating balloon options should be an easy task.