What it means
Standard options pay out based on the price at expiry. A one-touch option is different because it is path dependent, meaning that what happens along the way matters.
Once the price touches the barrier, the payout is earned, even if the price falls back immediately afterwards. These products are often called exotic or binary options.
The payout is fixed in advance, such as $100,000, and is paid either when the barrier is touched or at expiry depending on the contract. The buyer's maximum loss is the premium, and the seller's maximum loss is the payout less the premium received.
The price of the option reflects the chance of touching the barrier. A barrier close to the current price is likely to be reached, so the premium is a high share of the payout, while a distant barrier costs little.
Higher volatility, which measures how widely prices swing, raises the chance of a touch and therefore the premium. Businesses use them mainly in foreign exchange.
A company that benefits from a currency staying below a certain level might buy a one-touch that pays out if the level is breached, using the payout to offset losses elsewhere. They are also used for speculation, with the buyer paying a small premium for a chance of a large payout.
There are important risks. The probability of touching is often less than people think, and the barrier may be reached by a brief spike in thin trading.
Contracts also set rules about which price counts, so the wording on how the barrier is monitored should be checked carefully.
In practice
Real-world examples.
Example
An exporter expects to lose money if the euro rises above a certain level against the dollar. She buys a one-touch with a $200,000 payout if the level is reached. If the currency spikes, the payout offsets part of her loss on unhedged sales.
Example
A fund manager believes a stock index will rally sharply but is unsure when. He pays a premium of $12,000 for a one-touch paying $50,000 if the index reaches a higher level within three months. He loses only the premium if the level is not reached.
Example
A bank sells one-touch options to corporate clients and hedges its risk by trading the underlying currency. Its traders monitor the barrier closely, because the hedge becomes difficult to manage when the price is near the level and the payout is about to be triggered.
Formula
Calculation
Premium is approximately payout x probability of touching the barrier (ignoring discounting and interest)
For a barrier above the price and no drift, the probability of touching is roughly twice the probability of finishing beyond the barrier at expiry.
Suppose the payout is $100,000 and the probability of finishing beyond the barrier is estimated at 17.5%.
Probability of touching = 2 x 17.5% = 35%.
Premium = 100,000 x 0.35 = $35,000.
If the barrier is touched, the buyer receives $100,000, a net gain of 100,000 - 35,000 = $65,000. If not, the buyer loses the $35,000 premium. Break-even probability for the buyer is 35,000 / 100,000 = 35%.Case study
Seen in the real world.
Silverline Imports is an illustrative, fictional company that buys goods priced in a foreign currency. Its finance director feared a sharp rise in the currency but did not want to pay for a full hedge on $5 million of purchases.
She purchased a one-touch option with a payout of $250,000 and a premium of $40,000, triggered if the currency rose 8% from the current level. Over the following months the currency drifted upwards but never reached the barrier, and the option expired worthless.
The company paid higher costs on its purchases, but the premium of $40,000 was far smaller than the cost of a full hedge. The finance director later reviewed the policy and concluded that a one-touch is a cheap but narrow tool: it pays only if the exact level is reached. The illustrative lesson is that it works as a targeted insurance against a spike and not as a general hedge.
Watch out
Common mistakes.
- Assuming the option pays out because the price ended near the barrier, when only an actual touch counts.
- Using it as a full hedge, when it pays a fixed amount that may not match the actual loss.
- Ignoring the contract wording on which price source and time of day count for touching the barrier.
Questions
People also ask.
What is the difference between a one-touch and a no-touch option?
A one-touch pays if the barrier is reached, while a no-touch pays if the barrier is never reached before expiry.
Why is the premium so high for nearby barriers?
A nearby barrier is more likely to be touched, so the chance of paying out is high and the seller charges more.
Who loses if the option is touched?
The seller pays the fixed payout, so the seller's loss is the payout less the premium it received.
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