Perpetual Option (XPO): What it Means, How it Works, Example

What Is a Perpetual Option (XPO)?

A perpetual option is a non-standard, or exotic, financial option that has no fixed maturity and no exercise limitation. While the life of a standard option can range from a few days to several years, a perpetual option (XPO) can be exercised at any time and without any expiration. Perpetual options are thus a form of an American option, whereas European options can be exercised only on the option's maturity date.

XPO contracts are also referred to as "non-expiring options" or "expirationless options."

Understanding Perpetual Options (XPOs)

An option contract gives its holder the right, but not the obligation, to purchase (for a call option) or sell (for a put option) a specific amount of the underlying security for a predetermined (strike) price at or before the option's expiration. A perpetual option grants the same sort of rights without expiration.

Perpetual options are technically classified as exotic options since they are non-standard, although they may be viewed as plain vanilla options since the only modification is the lack of a determined expiration date. For some investors, these represent an advantage over other instruments (especially when dividends and/or voting rights are not a high priority) because the strike price on a perpetual option enables the holder to choose the buy or sell price point and their potential to buy/sell at that price doesn't expire. In addition, XPOs can be preferable to standard options because they eliminate the expiration risk.

While perpetual options have some favorable features and have been the focus of some interesting academic work in financial economics, the practical use of XPOs by traders is limited. No registered options exchanges list perpetual options in the U.S. or abroad, so if and when they do trade they will occur in the over-the-counter (OTC) market. Therefore, the typical trader will never have contact with one of these options. Finding a proper value would be difficult when buying, and writing a perpetual option exposes the trader to risk for as long as that option remains open.

One example of an exotic OTC option that combines a perpetual option with a lookback feature is the Russian option. This has nothing to do with where the option is traded. This option is also a theoretical idea and is not actively traded anywhere. Different types of options are often given names of countries in order to quickly differentiate one style from another.

Pricing a Perpetual Option

European options are priced using the Black-Scholes-Merton model, and American options that have an early exercise feature are priced typically with a binomial or trinomial tree model. Having no expiration date, perpetual options are somewhat different to price, often using a Martingale model, although multiple approaches have been put forth in academic papers.

In order to price these options, the conditions for when to optimally exercise must be established, which could be defined as when the underlying asset reaches the optimal exercise barrier. This barrier price is the optimal exercise point and is defined mathematically as where the present values of the option's price and the payoff converge.

Example of a Perpetual Option

Since perpetual options are not actively traded, to understand them we can look at a normal option and then take out the expiration date.

Assume a trader is interested in a perpetual call option on the price of gold, based on the nearest futures contract price. Because the contracts are non-standard, they can be based on any instrument desired and for any amount, such as one ounce of gold or 10,000 ounces.

Assume that gold currently trades at $1,300. The trader selects a strike price of $1,500. Therefore, if the price of gold rises above $1,500, the contract will be in the money. That does not mean the trader will be making money, though. The price of the option, or premium, will determine at which point it becomes profitable to exercise the option.

Since the option has no expiry, the option writer is on the hook indefinitely if the price of gold rises to $2,000, $5,000, or even $10,000 or higher in the years or decades to come. Such an option, therefore, wouldn't be cheap. A standard option extending out 1.5 years can cost 10% of the value of the underlying (fluctuating dramatically, up or down, based on volatility). Therefore, a perpetual option could easily cost 50% or more of the underlying.

Assume someone is willing to sell a perpetual option of this kind of $550 on one ounce of gold. In order for the buyer to make money, the price of gold (based on the nearest futures contract) would need to rise above $2,050 ($1,500 + $550). As long as the price of gold is below that, the trader has hope and time but not profits. If the price of gold is at $1,700, the option is worth $200 but the trader paid $550, so it isn't worth more than what they paid yet. With a perpetual option, once it is making money, there is also the problem of deciding when to exercise it.