Definition of perpetual option (XPO)

What is a perpetual option (XPO)?

A perpetual option is a non-standard or exotic financial option that has no fixed maturity or exercise limitation. While the life of a standard option can vary from a few days to several years, a perpetual option (XPO) can be exercised at any time and without expiration. Perpetual options are therefore a form of US option, while European options can only be exercised on the option expiration date.

XPO contracts are also called “no expiration options” or “no expiration options.”

Key takeaways

  • A perpetual option (XPO) is an option that has no expiration date or restrictions on when it can be exercised.
  • Perpetual options are not actively traded or traded anywhere. If they trade, which is rare, the transaction would take place on the OTC market.
  • Pricing a perpetual option is difficult, as academics still publish articles on the different ways it could be achieved.

Understanding Perpetual Options (XPO)

An option contract gives its holder the right, but not the obligation, to buy (for a call option) or sell (for a put option) a specified amount of the underlying security for a predetermined price (exercise) at or before of the expiration of the option. . A perpetual option grants the same type of rights without expiration.

Perpetual options are technically classified as exotic options since they are not standard, although they can be seen as simple options, since the only modification is the lack of a certain expiration date. For some investors, these represent an advantage over other instruments (especially when dividends and / or voting rights are not a high priority) because the exercise price of a perpetual option allows the holder to choose the purchase or sale price and its buying potential. Selling at that price does not expire. Additionally, XPOs may be preferable to standard options because they eliminate the risk of expiration.

While perpetual options have some favorable features and have been the focus of some interesting academic work in financial economics, the practical use of XPOs by traders is limited. Unregistered option exchanges list perpetual options in the US or abroad, so if traded, they will occur over the counter (OTC). Therefore, the typical trader will never have contact with one of these options. Finding a suitable value would be difficult when buying, and writing a perpetual option exposes the trader to risk as long as that option remains open.

An example of an exotic over-the-counter option that combines a perpetual option with a function of the past is the Russian option. This has nothing to do with where the option is traded. This option is also a theoretical idea and is not actively marketed anywhere. Different types of options are often given country names to quickly differentiate one style from another.

Pricing a perpetual option

European options are priced using the Black-Scholes-Merton model, and American options that have an early exercise function are typically priced using a binomial or trinomial tree model. Having no expiration date, perpetual options differ somewhat from price, often using a Martingale model, although multiple approaches have been featured in scholarly articles.

To value these options, the conditions of when to exercise optimally must be established, which could be defined as when the underlying asset reaches the optimal exercise barrier. This barrier price is the optimal exercise point and is mathematically defined as where the present values ​​of the option price and the payout converge.

Example of a perpetual option

Since perpetual options are not actively traded, to understand them we can look at a normal option and then take the expiration date.

Suppose a trader is interested in a perpetual call option on the price of gold, based on the price of the nearest futures contract. Because the contracts are not standard, they can be based on any desired instrument and for any amount, such as one ounce of gold or 10,000 ounces.

Assume that gold is currently trading at $ 1,300. The trader selects a strike price of $ 1,500. Therefore, if the price of gold rises above $ 1,500, the contract will be in the money. However, that does not mean that the merchant is making money. The price of the option, or premium, will determine when it will be profitable to exercise the option.

Since the option does not expire, the option issuer is hooked indefinitely if the price of gold increases to $ 2,000, $ 5,000, or even $ 10,000 or more in the years or decades to come. Therefore, such an option would not be cheap. A standard option that spans 1.5 years can cost 10% of the value of the underlying (fluctuating dramatically, up or down, depending on volatility). Therefore, a perpetual option could easily cost 50% or more of the underlying.

Suppose someone is willing to sell such a $ 550 perpetual option for one ounce of gold. For the buyer to make money, the price of gold (based on the closest futures contract) would have to rise above $ 2,050 ($ 1,500 + $ 550). As long as the price of gold is below that, the trader has hope and time, but no profit. If the price of gold is $ 1,700, the option is worth $ 200 but the trader paid $ 550, so it is not worth more than what they paid yet. With a perpetual option, once you are making money, there is also the problem of deciding when to exercise it.

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Mark Holland

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