Chooser option

Overview

In finance, a chooser option is a special type of option contract. It gives the purchaser a fixed period to decide whether the derivative will be a European call or put option. In more detail, a chooser option has a specified decision time

t

1

{\displaystyle t_{1}}

, where the buyer has to make the decision described above. Finally, at the expiration time

t

2

{\displaystyle t_{2}}

the option expires. If the buyer has chosen that it should be a call option, the payout is

max ( S − K , 0 )

{\displaystyle \max(S-K,0)}

. For the choice of a put option, the payout is

max ( K − S , 0 )

{\displaystyle \max(K-S,0)}

. Here

K

{\displaystyle K}

is the strike price of the option and

S

{\displaystyle S}

Replication

For stocks without dividend, the chooser option can be replicated using one call option with strike price

K

{\displaystyle K}

and expiration time

t

2

{\displaystyle t_{2}}

, and one put option with strike price

K

e

− r (

t

2

−

t

1

)

{\displaystyle Ke^{-r(t_{2}-t_{1})}}

and expiration time

t

Valuation characteristics

Chooser options are generally more expensive than otherwise comparable plain-vanilla options because they give the holder the right to decide later whether the contract will become a call or a put. In an overview of exotic options, chooser options are described as contracts that allow that decision to be made on a fixed date before expiration, which gives the holder additional flexibility relative to a standard option. Academic treatments of chooser-option pricing identify the choice date as a key determinant of value, since the option's premium reflects the value of delaying the decision between a call and a put until more information about the underlying asset's price path is available.

Bibliography

Yue-Kuen Kwok, Compound options (from Derivatives Week and Encyclopedia of Financial Engineering and Risk Management) [1]