Through the course of this article, we will understand all about what a Russian Option is and how it works.
A Russian option, sometimes referred to as a “reduced regret option,” is an exotic Option with no expiry date and a lookback clause. This implies that the owner of a Russian option can wait as long as they like before using it, and they can even exercise it at the best price it has ever exchanged for, irrespective of its current price.
Russian options are barely used in practice because they would demand extremely high premiums due to the extremely advantageous terms received by the option holder.
What is Russian Option?
Larry Shepp and A. N. Shiryaev first introduced the Russian Option in a 1993 essay published in the scholarly journal The Annals of Applied Probability.
They described a sort of “new put option” in which the option holder has the power to preserve the Option indefinitely, exercise it at any time, and earn either the current price or the highest price (discounted) at which the Option has ever traded in the past upon implementing the contract.
“The buyer need look at the fluctuations [between the purchase time and the exercise time] only occasionally and enjoys having little or no regret that he did not exercise the option at an earlier time (except for the discounting),” the authors stated.
Shepp and Shiryaev explained that they call it the Russian Option, partially to differentiate it from the American and European options, which have a predetermined term and no precise mechanism for calculating the value. But also “to our knowledge, no such regretless option is currently traded in any existing market despite its evident appeal.”
Many investors would want to acquire such an option because it benefits the option holder greatly. Despite the fact that the Russian option notion has sparked a lot of scholarly debate, it has never been used in practice. If it were to become a reality, it would very certainly be traded over the counter (OTC) and would come with significant premiums. These limits are likely to make Russian options unattractive for most real-world traders.
Even though the Russian Option is not traded in practice—at least, not on any major exchange or market—it has led to the invention of numerous notable formulas for the option value, ideal exercise time, and projected exercise time, all of which have had a significant impact on probability theory.
It is also important to note that in 1995, Shepp and Shiryaev released “A New Look at Pricing of the ‘Russian Option,'” a follow-up work that provided a simplified method for calculating a fair value for the Option.
How the Russian Option Works
John is an options trader who prefers using OTC transactions to invest in exotic options. He is able to find a willing counterparty to bargain a Russian option, which is nearly never traded in the real world.
John and his counterparty have agreed upon the following terms: John is the option holder on the deal, which is stated as a put option with silver as the underlying asset. The spot price for silver is around $15 per ounce at the time they negotiated the contract.
John obtains the right (but not the responsibility) to sell a specific quantity of silver to his counterparty at a strike price of $10 per ounce, which is much lower than the current market price.
Because it is a Russian option, the option contract has no specified maturity date. Therefore, John can execute the put option at any moment and trade the silver to his counterparty at any rate that existed during the contract’s life.
John is obliged to pay a considerable premium to his counterparty in return for this flexibility, to the point where, even with the favorable terms of the option contract, John is anything but assured that he would profit from the transaction.
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What Is the Importance of a Russian Option?
A Russian option has no expiration date, allowing the holder to exercise whenever he believes the underlying asset has reached the most advantageous level, irrespective of how short or long the holding period is. Russian options are advised for experienced investors in this regard because they have the potential for considerable risk if kept for extended periods of time.
A Russian option may well be executed as a lookback option in accordance with American or mid-Atlantic agreement standards based on the underlying asset’s most beneficial market price during the Option’s life. Russian options are unique in that they do not have an expiration date like other lookback options.
Unlike many other options, the Russian Option presents users and investors with a high-end option because of its no expiration date feature. This makes it possible for investors and holders to make the most out of this Option since there is clear freedom where the Option is not going to expire.
It is also important for investors and Option holders to understand that the Russian options present some high-level risks which can affect inexperienced traders; therefore, this type of Option should be practiced by expert options traders who are already grounded in the options trading market.