Rainbow Option

Definition

Rainbow option is a derivative exposed to two or more sources of uncertainty, as opposed to a simple option that is exposed to one source of uncertainty, such as the price of underlying asset.


Rainbow Option

What is ‘Rainbow Option’

A single option linked to two or more underlying assets. In order for the option to pay off, all the underlying assets must move in the intended direction.

Explaining ‘Rainbow Option’

The underlying securities can have different characteristics, such as expiry date and strike price, but all must move in the way the option holder has bet they will.

Here’s a sports-betting analogy that demonstrates a rainbow option: suppose you’re at a baseball tournament with three fields backing one another. One game is halfway through, a second is just starting and a third starts in an hour. A type of bet that’s analogous to a rainbow option is one that earns you a profit if you pick all three winners, but gets you nothing if any one team you pick is a loser.

Further Reading