What is a basket option?
What is an option?
An option is a derivative financial instrument that gives its buyer the right to buy or sell the underlying asset at a predetermined price for a stipulated period. The right to buy or sell can be exercised by the buyer at his/her discretion within the stipulated duration. The buyer has no obligation to exercise the option. However the seller is obligated to abide by the contract, should the buyer choose to exercise his/her option. After the duration stipulated in the option contract is over and the option isn't exercised before it, then it becomes null and void as each option contract has an expiration date.
What is an exotic option?
An exotic option contract is an option contract that differs from the standardized option contracts available in the market. It may be in regards to payment structures, duration, expiration dates, strike prices etc
What is a basket option?
A basket option is an exotic option. Here the underlying asset is essentially a grouping or basket of an asset, such as commodities, stocks, securities, or currencies.
The right to buy or sell the basket at a predetermined price for a stipulated period, can be exercised by the buyer at his/her discretion within the aforementioned duration. The buyer is not obligated to exercise the option.
The point of contention between a standardized options contract and a basket option contract is the strike price. For basket options, the constituents weighted value defines the strike prices that are to be considered.
How are basket options different from index options?
An index option is standardized and traded on exchanges whereas a basket option is customisable and traded over-the-counter. However technically, an index option is also a basket option of sorts as the underlying asset is a weighted grouping of component stocks. But as a third party calculates and maintains it, index options have more in common with individual options and as they are not exotic in nature.
Salient features of basket options
Basket options are customized according to the needs of the buyer and seller.
Basket options are traded Over-the-counter (OTC) which is why they are not as liquid as standardized options traded on exchanges.
Benefits of investing in basket options
The investors save money on commissions and fees as they only have to take a single position instead of multiple ones when they invest in a basket option.
Basket options promote efficiency by allowing the investor to hedge the risk on multiple securities simultaneously in a single transaction.
Basket options can be used to temporarily diversify the portfolio.
Basket options are customisable to accommodate the needs of both the buyer and the seller.
Drawbacks of investing in basket options
As each basket is tailor-made according to the needs of the counterparties involved and traded over-the-counter. It is difficult to exit such positions before expiry as finding another party to offset their current position can be difficult. This restricts liquidity, thus blocking the capital deployed.
A basket option doesn't necessarily mimic the pattern of individual components with regards to changes in volatility, time, price etc. This may cause the investor to lose out on opportunities that he/she could have benefited from, had he/she taken individual positions.
Let's use an example to understand where a basket option can be used.
ABC Company operates in many countries. So they need to maintain currency reserves in all these countries for efficiently conducting their business. Their costs and profits are affected due to currency risk. So they enter into a currency basket option. They buy a basket option of US Dollars, Singapore Dollars and United Arab Emirates Dirham in exchange for Indian Rupees as currency baskets are settled in the holder's home currency. This helps them to reduce the commissions and fees that would otherwise be used to take individual positions.