What it is:
How it works (Example):
A traditional option contract gives the holder the right to buy (call option) or sell (put option) an underlying asset at a preset price, known as the strike price, by the contract's expiration date. A ladder option, as the name suggests, is an exotic option that features a number of additional price levels above ( ladder option) or below (put ladder option) the strike price. The owner of the option profits according to the highest (call ladder option) or lowest (put ladder option) of these price levels reached by the underlying prior to the option's expiration date. The holder profits even if the underlying asset's price returns to a lower level.
The concept is best illustrated with an example:
Suppose a call ladder option on stock ABC has a strike price of $100, additional price levels of $110, $125, and $155, and an expiration date of December 31. The market price of stock ABC reaches $140 on December 15, but then declines to $105 by December 31. The owner of the option will receive a payout commensurate with the $125 price level the stock breached on December 15. Had the market price surpassed the $155 price level, the holder would have received the profit that corresponded to that price level.
Why it Matters:
The "rungs" of a ladder option increase the number of profitable outcomes and further reduce risk. In addition, unlike traditional options, profits are locked in once the market price reaches one of these rungs regardless of whether the price stays above the rung.
As should be expected, because there are more profit opportunities and lower risk associated with ladder options, the premiums paid for ladder options are more expensive than those paid for plain vanilla options.