A rainbow option is an investment strategy in which a single option is connected with more than a single underlying asset. The securities underlying the option may be different in term of the strike prices or even the expiration dates, but all the securities associated with the option must move in the direction predicted by the investor before the investment can pay off. While this means there is a higher degree of uncertainty with the rainbow option, the return that can be generated by this type of arrangement may be significant.
One of the easiest ways to understand how a rainbow option works is to consider a real estate deal in which the realtor must sell three properties for a single customer before earning a commission. One property may be a private residence, one a storefront, and the third an apartment building. In the event that the realtor is able to sell one of the properties but not the other two, then no commission is earned. Should the realtor persevere and eventually sell all three properties, then he or she receives a commission based on the cumulative sale price for all three properties. Depending on the circumstances, the realtor may have to work for a number of years before selling all three properties and actually see any return for his or her efforts.
The rainbow option works in much the same manner. Assuming there are two different types of underlying assets related with an option, both of them must perform according to expectations before the investor earns any type of return from owning that option. Since time is not necessarily a factor, it is possible for one asset to perform as expected immediately, and the remaining asset to require a longer period, perhaps a year or more, to meet the anticipated benchmark. Only after both have crossed the projected threshold will the investor actually realize a return.
Structuring a rainbow option is something that must be done with care. The outlook for all underlying assets must be assessed and predicted properly in order for the strategy to work. Failure to look closely at each asset can lead to situations where one asset performs very well while the other exhibits little to no growth. The end result is that the investor is left holding an option that is earning nothing, and may end up selling the option at a loss if it becomes apparent that it will be some time until all underlying assets generate the profit necessary to achieve a return.