Gap Options Can Have Negative Payoffs When Triggered

Summary

The document examines a gap option with a trigger level that differs from the strike. Its payoff is zero below the trigger and equals the underlying price minus the strike above it. When the underlying finishes above the trigger but below the strike, that formula produces a negative payoff, raising the question of whether the holder can be made to exercise at a loss.

The response says that trigger contracts can be structured so that crossing a threshold causes an unfavorable outcome, and gives a reference-rate swap cancellation as an example. It advises viewing such products as derivatives rather than assuming every instrument called an option gives its holder a costless choice at exercise. The exchange does not explain the contract’s legal mechanics, settlement conventions, or how the quoted payoff is enforced, so those details depend on the specific terms.

Key ideas

• A gap payoff can be negative when the underlying is between its trigger level and strike.
• Trigger contracts can produce unfavorable outcomes after a reference level is crossed.
• The label “option” does not guarantee that every contract gives the holder a favorable exercise choice.
• The document does not detail the legal or settlement mechanics of a particular contract.

Tags

# Forced to exercise gap options


# Forced to exercise gap options












I was reading a textbook and came across some surprising stuff in the section about gap options.

> Let $X$ be a payoff function such that $X=\Big\{\matrix{0 \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ , \ \ \ \ S(T)\leq K_2 \cr S(T)-K_1\ \ \ \ ,\ \ \ \ \ S(T)> K_2}$

The payoff would be negative if $K_2<S(T)< K_1$. The textbook says:

> Notice that sometimes the option holder is forced to exercise at a loss! Perhaps the name "option" is a misnomer.

This seems surprising. Is it true that gap options can incur loss for the option holder beyond the initial price? Can you be "forced" to exercise options?

I looked online and didn't find anything. Also, feel free to edit/migrate if necessary.

## Answer by Mark Joshi (score 1)

https://quant.stackexchange.com/a/18703

Trigger contracts certainly exist and sometimes the trigger is out of the money and so yes the holder loses out. I have seen traded swaps that cancel when a reference rate is passed and the cancelling is disadvantageous.

Stop thinking of the contracts as "options" and start thinking of them as derivatives.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.