Perpetual Option

What Is a Perpetual Option?

A perpetual option, often denoted as XPO, is a unique and non-standard financial option. Unlike standard options, which come with fixed expiration dates, perpetual options have no predetermined maturity date, and there are no exercise limitations imposed upon them.

Standard options typically come with a specific lifespan, ranging from as short as a few days to several years. In contrast, a perpetual option defies this time constraint by allowing the holder the right to exercise it at any time, without any constraints related to expiration dates. In essence, perpetual options function much like American options, as they grant the flexibility to buy or sell the underlying asset whenever it is strategically advantageous. This is in contrast to European options, which can only be exercised on their predetermined maturity date.

The contracts associated with perpetual options are often referred to by various terms, including "non-expiring options" or "expirationless options." These labels reflect the essence of perpetual options, highlighting their key feature of indefinite viability in the market.

Perpetual options are particularly relevant in markets where traders seek flexibility and opportunities for strategic decision-making without the time pressures imposed by traditional options with fixed maturities. They are a valuable tool for those active in actively traded markets, including both centralized exchanges and decentralized exchanges, where liquidity fragmentation can influence pricing dynamics.

How do Perpetual Options Work??

Perpetual options operate on a unique and intriguing principle in the world of financial derivatives. To understand how perpetual options work, it’s essential to grasp their key characteristics and distinctions from traditional options.

An option contract is a financial instrument that bestows specific rights upon its holder. These rights allow the holder to either buy (in the case of a call option) or sell (in the case of a put option) a predetermined amount of the underlying security. This transaction occurs at a specified price, known as the strike price, and can be executed either on or before the option’s expiration date. However, perpetual options deviate from this standard in a fundamental way—they lack an expiration date.

Perpetual options fall under the category of exotic options because they do not adhere to the typical standards of options contracts. Despite their exotic classification, they can be seen as akin to plain vanilla options, with the primary difference being the absence of a fixed expiration date. This means that holders of perpetual options retain the right to choose when to exercise their option, and this right remains indefinitely open.

Despite their favorable characteristics and academic interest in financial economics, the practical usage of perpetual options remains limited. Notably, these options are not listed on registered options exchanges in the United States or other markets worldwide. Consequently, if and when they are traded, it occurs in the over-the-counter (OTC) market. The absence of standardized exchange listings and trading venues means that typical traders rarely encounter perpetual options. Their niche status in the financial landscape makes it challenging to establish a proper market value when purchasing them. Furthermore, writing a perpetual option exposes traders to ongoing risk as long as the option remains open.

One example of an exotic OTC option that combines the characteristics of a perpetual option with a unique feature is the Russian option. This specific option, despite its name, is a theoretical concept and is not actively traded in any market. Financial instruments like the Russian option, with unconventional characteristics, often receive names that include references to countries to quickly distinguish them from standard options.

Advantages and Disadvantages of an XPO

Advantages

1. No Expiration Risk. One of the most significant advantages of a perpetual option is the complete absence of an expiration date. This means that holders of XPO contracts do not face the risk of their option expiring worthless, as is the case with traditional options. This advantage provides peace of mind to investors, ensuring that the option remains viable indefinitely.

2. Buy/Sell Flexibility. Perpetual options grant investors unparalleled flexibility when it comes to deciding when to buy or sell their contracts. The absence of an expiration date means that investors can exercise the option at their preferred timing, aligning with their strategic objectives and market conditions.

3. Lower Trading Costs. XPOs offer an economic benefit by eliminating trading costs associated with rolling over options. Traditional options often require the rolling over of positions to extend their expiration, incurring additional fees. With perpetual options, this concern is eliminated, leading to lower overall trading costs.

Disadvantages

1. Deciding When to Exercise. The absence of an expiration date in perpetual options introduces a unique challenge for investors—deciding when to exercise the option. Without a predefined expiration, investors must consider the time value of money when evaluating the optimal exercise timing. This decision becomes more complex, as investors need to assess whether they have achieved a satisfactory return on investment, given the time they’ve held the contract. Alternatively, they must evaluate whether allocating their capital to another security could yield a better return.

2. Liquidity Risk. Perpetual options have a non-standard nature, making them less common in the market. As a result, there is a limited pool of investors in the secondary markets interested in purchasing these contracts. This lack of liquidity can pose a risk for investors, as they may not be able to sell their contracts as quickly as they desire. Limited market participants can hinder the ease of entering or exiting positions in perpetual options.

Pricing a Perpetual Option

Pricing a perpetual option is a unique challenge in the world of financial derivatives due to its distinct characteristics, notably the absence of an expiration date. While European options rely on the Black-Scholes-Merton model and American options with early exercise features are typically priced using binomial or trinomial tree models, perpetual options require a different approach to determine their fair value.

Given the perpetual nature of these options, pricing often involves the utilization of a Martingale model, although various alternative methodologies have been proposed and explored in academic research. The Martingale model serves as a foundation for pricing perpetual options, allowing for a better understanding of their intrinsic value.

The key consideration in pricing perpetual options is the establishment of conditions for optimal exercise. Optimal exercise is defined as the point at which it becomes advantageous for the option holder to exercise the option. This decision hinges on the underlying asset’s performance and when it reaches a specific level known as the optimal exercise barrier. Mathematically, the optimal exercise barrier represents the point at which the present values of the option’s price and the payoff converge, signaling the ideal moment for the option holder to exercise their right to buy or sell the underlying asset.

Determining this optimal exercise barrier is a critical step in pricing perpetual options, as it signifies the point at which exercising the option becomes favorable and, therefore, helps ascertain the option’s fair market value.

Example of a Perpetual Option

Let’s consider a trader interested in a perpetual call option based on the price of gold, using the nearest futures contract price as a reference. Perpetual options are not actively traded, so to understand them, we’ll remove the expiration date from a standard option.

1. Underlying Asset: Gold

2. Current Gold Price: $1,300 per ounce

3. Strike Price: $1,500 per ounce

In this example, the trader selects a strike price of $1,500. If the price of gold rises above this strike price, the contract becomes "in the money." However, being "in the money" doesn’t guarantee profits; the option premium plays a crucial role in determining when the option becomes profitable to exercise.

Since perpetual options have no expiry date, the option writer (seller) remains exposed to the trade indefinitely. This means that if the price of gold were to skyrocket in the future, such as reaching $2,000, $5,000, or even $10,000 or higher over the years or decades, the option writer would be obligated to fulfill the option, which can be costly. The absence of an expiration date increases the cost of perpetual options significantly.

For instance, a standard option with a 1.5-year expiration might cost around 10% of the underlying’s value, subject to volatility. In contrast, a perpetual option could be much more expensive, costing 50% or even more of the underlying’s value.

Now, let’s assume that someone is willing to sell a perpetual call option on one ounce of gold for $550. For the buyer of this option to make a profit, the price of gold (based on the nearest futures contract) would need to rise above $2,050 ($1,500 + $550). As long as the gold price remains below this level, the trader has time and potential, but they have not yet achieved profits.

For example, if the price of gold is at $1,700, the option is worth $200. However, since the trader paid $550 for the option, they haven’t recouped their initial investment yet. With a perpetual option, once it starts making money, the challenge remains in deciding the optimal time to exercise it, considering the ongoing potential for market fluctuations.

This example illustrates the complexity of perpetual options, highlighting the absence of an expiration date and the associated costs and challenges they present to both buyers and sellers.