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What Is a Path Dependent Option?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 05 September 2016
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    2003-2016
    Conjecture Corporation
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A path dependent option is a type of investment opportunity that will generate returns based on the projected changes in price over a specific period of time. This is in contrast to investments that are known as straight options that are based on the value of the asset that underlies the option, either at the time the option is called or reaches the date of expiration. There are a number of different types of options that are considered path dependent in nature, including the lookback option, the barrier option, and the Asian option.

The defining characteristic of a path dependent option is that the benefits derived are directly connected with the movement or path that the value of the underlying asset takes for the amount of time that the investor intends to hold onto that asset. That movement makes it possible to set price requirements at specific points in time during that period, with the potential to either earn or lose money along the way. Assuming the investor has accurately predicted what is likely to happen at each of those price points, the potential to generate a significant amount of revenue from the holding is very high.

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It is important to note that accurate projection of the path that the pricing for the underlying asset will take is crucial if the investor is to make money from the path dependent option. This means that rather than being concerned simply with what the price will be at the end of the period under consideration, there is also the necessity of projecting what will happen with that price at predetermined points between the date that the asset is acquired and the date that the investment is called or reaches expiration. While a more intense process that going with a straight option, the potential to generate returns using this approach is extremely high.

Along with the potential returns that can come from correctly assessing the path of movement of the pricing on the underlying asset, there is some degree of risk associated with a path dependent option. Unanticipated market changes that affect those price movements may lead to losses. Failure to consider all known factors when considering this type of option for purchase will lead to incomplete projections that could be very costly. While the potential returns are excellent when the predictions are accurate, those returns can be greatly diminished when the decision to go with a path dependent option is based more on intuition than on factually grounded projections.

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