# Lookback Options Explained: Benefits, Pricing, and Fixed vs. Floating Types

## What Is a Lookback Option?

A lookback option is an exotic option that lets investors use the asset’s past prices to maximize profit. These options can be expensive and are usually traded over-the-counter (OTC). There are two main types: fixed lookback options, which set a strike price based on the best past price, and floating lookback options, which adjust the payoff depending on the highest or lowest price during the option’s life.

### Key Takeaways

*   Lookback options are a type of exotic option that provides the unique feature of allowing holders to exercise options at the most advantageous price of the underlying asset during the option's lifespan, potentially minimizing the risk of market timing mistakes.  
    
*   There are two main types of lookback options: fixed strike and floating strike. Fixed strike options have a predetermined strike price and allow for choosing the most favorable market price at expiration, while floating strike options automatically set the strike price to the most favorable market price during the contract's timeline.  
    
*   Despite their benefits, lookback options are generally more expensive due to their flexible nature and are available only over-the-counter, not on standard exchanges. This makes them less accessible and often cost-prohibitive for some investors.  
    
*   Lookback options can be particularly useful in volatile markets, as they allow investors to benefit from the peak or trough price movements of the asset within the contract's duration.  
    
*   The process of settling a lookback option usually results in cash settlement, where the profit is calculated based on the difference between the most favorable price during the contract period and the strike price, minus the cost of the option.

## How Lookback Options Work and Their Benefits

Also known as a hindsight option, a lookback option allows the holder the advantage of knowing history when determining when to [exercise](https://www.investopedia.com/terms/e/exercise.asp) their option. This type of option reduces uncertainties associated with the timing of market entry and reduces the chances the [option](https://www.investopedia.com/terms/o/option.asp) will expire worthless. Lookback options are expensive to execute, so these advantages come at a cost.

As a type of [exotic option](https://www.investopedia.com/terms/e/exoticoption.asp), the lookback allows the user to "look back," or review, the prices of an [underlying asset](https://www.investopedia.com/terms/u/underlying-asset.asp) over the lifespan of the option after it has been purchased. The holder may then exercise the option based on the most beneficial price of the underlying asset. The holder can take advantage of the widest differential between the [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) and the price of the underlying asset. Lookback options do not trade on major exchanges. Instead, they are unlisted and trade [over-the-counter](https://www.investopedia.com/terms/o/otc.asp) (OTC).

Lookback options are [cash-settled options](https://www.investopedia.com/terms/c/cash-settled-options.asp), which means the holder receives a cash settlement at execution based on the most advantageous differential between high and low prices during the purchase period. Sellers of lookback options would price the option at or near the widest expected distance of price differential based on past volatility and demand for the options. The cost to purchase this option would be taken up front. The settlement will equate to the profits they could have made from buying or selling the underlying asset. If the settlement was greater than the initial cost of the option, then the option buyer would have a profit at settlement, otherwise a loss.

## Comparing Fixed and Floating Strike Lookback Options

When using a fixed strike lookback option, the strike price is set or fixed at purchase, similar to most other types of [option trades](https://www.investopedia.com/terms/o/optionscontract.asp). Unlike other options, however, at the time of exercise, the most beneficial price of the underlying asset over the life of the contract is used instead of the current market price. In the case of a call, the option holder can review the price history and choose to exercise at the point of highest return potential.

For a put option, the holder may execute at the asset's lowest price point to realize the greatest gain. The [option contract](https://www.investopedia.com/terms/o/optionscontract.asp) settles at the selected past market price and against the fixed strike.

When using a floating strike lookback option, the strike price is set automatically at [maturity](https://www.investopedia.com/terms/m/maturity.asp) to the most favorable underlying price reached during the contract's life. Call options fix the strike at the lowest underlying asset price. Adversely, put options fix the strike at the highest price point. The option will then settle against the [market price](https://www.investopedia.com/terms/m/market-price.asp) calculating the profit or loss against the floating strike.

The fixed strike option solves the market exit problem—the best time to get out. The floating strike solves the market entry problem—the best time to get in.

## Real-World Examples of Lookback Options in Action

In example number one, if you assume a [stock](https://www.investopedia.com/terms/s/stock.asp) trades at $50 at both the start and end of the three-month option contract, so there is no net change, gain, or loss. The stock's path is the same for both fixed and floating strike versions. At one point during the life of the option, the highest price is $60, and the lowest price is $40.  

*   For a fixed strike lookback option, the strike price is $50. The best price during the lifespan is $60. At strike, the stock is $50. The profit for the call holder is $60 - 50 = $10.
*   For a floating strike lookback option, the lowest price during the lifespan is $40. At maturity, the stock is $50, which is the strike price. The holder's profit is $50 - 40 = $10.

The [profit](https://www.investopedia.com/terms/p/profit.asp) is the same because the stock moved the same amount higher and lower during the life of the option.

In example two, assume the stock had a high of $60, a low of $40, and closed at $55, giving a net gain of $5.

*   For a fixed strike lookback option, the highest price is $60. The strike price is $50, which was set at purchase. Profit is $10 (60 - 50 = 10).
*   For a floating strike lookback option, the strike price is $55, which is set at option maturity. The lowest price is $40. Making a profit of $15 (55 - 40 = 15).

In example three, assume the stock closed at $45, resulting in a net loss of $5.

*   For a fixed strike lookback option, the highest price is $60. Less the strike price of $50, which was set at purchase. Gives a profit of $10 (60 - 50 = 10).
*   For a floating strike lookback option, the strike price is $45, which is set at option maturity. Less the lowest price of $40, Gives a profit of $5 (45 - 40 = 5).

## The Bottom Line

Lookback options are exotic contracts that let investors exercise at the most favorable price during the lifetime of the option. Fixed strikes help with timing exits, while floating strikes optimize entry. They’re usually expensive, traded over-the-counter, and can boost potential gains. Keep in mind, though, that their high costs may reduce any overall profits you can earn.