Outperformance options are a specific type of exotic options with a payoff based on the relative performance of two assets. It can be two stocks, two ETFs, two indexes, or two currencies for example. Those options are basically traded in the OTC market. Finally, they are European style and cash-settled most of the time.
The payoff of outperformance options:
The payoff of an outperformance call between a long basket and a short basket is the following:
Outperformance call = Max ( ((Basket-Long t1 / Basket-Long t0) – (Basket-Short t1 / Basket-Short t0)) – K ; 0)
Basket-Long t1 / Basket-Long t0 = ∑ wi x (Si, t / Si, t0)
Basket-Short t1 / Basket-Short t0 = ∑ wi x (Si, t / Si, t0)
K = Strike Price
Traders are using those options for speculation or hedging purposes. Let’s take a basic example, a trader purchase an outperformance call, where he will gain if the CAC 40 index outperforms the DAX 30 index until expiration. If at maturity the CAC 40 index outperforms the DAX 30 index, the trader will gain from the price difference between the two indexes. However, if the CAC 40 index has underperformed the DAX 30 index over the option’s life span, the call will expire worthless and the trader will not exercise it.
Finally, it is interesting to highlight that when the implied correlation between the two underlying is greater than 0.5, the outperformance option will be less expensive than a vanilla option.