I was reading a textbook and came across some surprising stuff in the section about gap options.

Let $X$ be a payoff function such that $X=\Big\{\matrix{0 \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ , \ \ \ \ S(T)\leq K_2 \cr S(T)-K_1\ \ \ \ ,\ \ \ \ \ S(T)> K_2}$

The payoff would be negative if $K_2<S(T)< K_1$. The textbook says:

Notice that sometimes the option holder is forced to exercise at a loss! Perhaps the name "option" is a misnomer.

This seems surprising. Is it true that gap options can incur loss for the option holder beyond the initial price? Can you be "forced" to exercise options?

I looked online and didn't find anything. Also, feel free to edit/migrate if necessary.

  • $\begingroup$ So trigger is $K_2$ and strike price is $K_1$. Suppose $S(0) = 100$, $K_1 = 1000$ and $K_2 = 0$. For a Gap call option, as long as $S(t) < 1000$, you will certainly lose money on the option. So the option price should be negative. $\endgroup$ – nathanesau Jul 5 '15 at 22:32
  • 1
    $\begingroup$ @Joseph Malle Which textbook? $\endgroup$ – user16651 Jul 5 '15 at 22:55
  • $\begingroup$ @BehrouzMaleki Actex's book for exam MFE by Johnny Li $\endgroup$ – sudo rm -rf slash Jul 6 '15 at 0:29

Trigger contracts certainly exist and sometimes the trigger is out of the money and so yes the holder loses out. I have seen traded swaps that cancel when a reference rate is passed and the cancelling is disadvantageous.

Stop thinking of the contracts as "options" and start thinking of them as derivatives.

  • $\begingroup$ Do gap options usually have trigger contracts as described in the question? $\endgroup$ – sudo rm -rf slash Jul 6 '15 at 0:31

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.