Each underlying asset in a rainbow option is a “color” of the “rainbow.” – Image Credit: Eric Rolph (CC by SA-2.5)
A rainbow option is an options contract based on the performance of more than one underlying asset. An investor can use a rainbow option to speculate on what asset will perform best or worst in a group, or how well the underlying assets perform as a whole. Each underlying asset can be considered a “color,” making the option a “rainbow.”
An analogy for rainbow options can be seen in horse racing. Rather than bet on an individual horse, a gambler can use a trifecta box to pick the top three finishers. If those three horses are the top three, regardless of order, than the bet pays out. Similarly, an investor can place a rainbow option on how well a group of assets will perform.
Rainbow options take on many different forms. In addition to the “best of” and “worst of” options mentioned above, spread options are based on the difference in price between two or more assets. Basket options derive their value from the net performance of all stocks in the group, or “basket.” An investor might call an option on an energy asset based on the rise or fall of a currency. Rainbow options come in seemingly endless varieties that can be tailored toward the investor’s specific strategy.
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