What it means
Most options are linked to a single price, such as whether a share ends above a set level. An outperformance option is linked to the difference between two assets, for example one stock index against another or one company against a competitor.
The buyer wins if the first asset performs better than the second, whatever happens to the overall market. This makes it useful for investors with a view on relative strength.
A fund manager who believes European shares will do better than American shares can express the view without worrying about a general market fall. It is also used to hedge, such as by a business that is exposed to the relative performance of two commodities.
The option is usually traded over the counter, meaning it is agreed directly with a bank. Its terms are tailored: the two assets, the period, the notional amount (the base figure used for the calculation) and whether the payoff is based on percentage returns or price changes.
The buyer pays a premium up front. The price depends on the volatility of each asset and on how closely they move together.
If the two assets are highly correlated, the difference between them is small and unlikely to be large, so the option is cheaper. If they move independently, the gap can be wider and the option costs more.
The risks are the loss of the premium and the counterparty risk of dealing directly with a bank. Valuation is also more complex than a simple option, and the buyer needs to understand the model used.
These options are mainly used by professional investors and corporate treasurers.
In practice
Real-world examples.
Example
A hedge fund believes that a particular airline will outperform the wider airline sector after a new route launch. It buys an outperformance option on the airline against a sector index. If the airline beats the index, the fund is paid, even when the whole sector falls.
Example
A food manufacturer is exposed to the relative price of wheat and maize because its recipes can use either. A bank structures an option that pays if wheat rises more than maize. The treasurer uses it to protect margins when wheat becomes more expensive than the alternative.
Example
An asset manager wants exposure to emerging markets relative to developed markets without investing large sums in either. The manager buys an option that pays on the difference in the two indices' returns, limiting the possible loss to the premium.
Formula
Calculation
Payoff = notional amount x maximum of (return on asset A - return on asset B, 0)
Net profit = payoff - premium
An investor buys an outperformance option on a $1,000,000 notional that pays if a technology index (A) beats a banking index (B) over one year. The premium is $20,000. At expiry, A has risen 14% and B has risen 9%, so the difference is 14% - 9% = 5%. The payoff is 1,000,000 x 0.05 = $50,000 and the net profit is 50,000 - 20,000 = $30,000. If A had returned less than B, the payoff would be zero and the loss would be the $20,000 premium.Case study
Seen in the real world.
Redwood Asset Management is a fictional fund company, and this is an illustrative story. Its strategist believed that smaller companies would beat large companies over the next year, but she was unsure whether markets in general would rise.
The fund bought an outperformance option with a $5,000,000 notional, paying on the excess return of a small-company index over a large-company index. The premium was $150,000, or 3% of the notional.
At expiry, small companies returned 11% and large companies 6%, an excess of 5%. The payoff was 5,000,000 x 0.05 = $250,000, giving a net profit of 250,000 - 150,000 = $100,000. The illustrative lesson is that this type of option isolates a relative view, but the premium has to be earned back before any profit appears.
Watch out
Common mistakes.
- Thinking the option pays if asset A simply rises, when it pays only if A beats B.
- Forgetting the premium when working out profit, which overstates the result.
- Ignoring correlation between the two assets, which strongly affects the price and the chance of a payout.
Questions
People also ask.
Can an outperformance option lose more than the premium?
For the buyer, no, because the loss is limited to the premium paid, while the seller can face large losses.
Who uses these options?
Mostly professional investors, banks and corporate treasurers who want to express or hedge a view on relative performance.
How is it different from a spread option?
They are closely related, as a spread option usually pays on the difference in prices, while an outperformance option pays on the difference in returns.
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