Rainbow Options: Understanding the Strategy & Investment Potential

The rainbow option is a specific type of option that many traders like to use. Here are the basics of the rainbow option and a consideration of whether it is a solid investment strategy.

Rainbow Option

A typical option will be exercised when the price of a security or commodity reaches a certain point. With the rainbow option, the option will be based on two different underlying assets. Both underlying assets will have to reach a certain threshold in order for the option to take effect. Otherwise, nothing will happen with the option.

Example

This type of option is typically associated with valuing natural resources. The value of a natural resource's deposit depends on two different variables. You have to know both the price of the resources and how much of the resource is available in the deposit. Therefore, both the price and the quantity must be met before a rainbow option will take effect.

Using the Strategy

Because multiple things have to go right for you to benefit with the rainbow option, this type of strategy is very risky. You are basically decreasing the odds of your success and putting money on it.