Exotic Option
What Is an Exotic Option?
Exotic options are a category of options contracts that contrast from traditional options in their payment structures, expiration dates, and strike prices. The underlying asset or security can shift with exotic options allowing for greater investment alternatives. Exotic options are hybrid securities that are frequently adjustable to the necessities of the investor.
Understanding Exotic Options
Exotic options are a variation of the American and European style options — the most common options contracts accessible. American options let the holder exercise their rights whenever before or on the expiration date. European options have less flexibility, just allowing the holder to exercise on the expiration date of the contracts. Exotic options are hybrids of American and European options and will frequently fall some place in between these other two styles.
A traditional options contract gives a holder a decision or right to buy or sell the underlying asset at a laid out price before or on the expiration date. These contracts don't commit the holder to execute the trade.
The investor has the privilege to buy the underlying security with a call option, while a put option gives them the ability to sell the underlying security. The cycle where an option converts to shares is called exercising, and the price at which it changes over is the strike price.
Exotic Option versus Traditional Option
An exotic option can differ in terms of how the payoff is determined and when the option can be exercised. These options are for the most part more complex than plain vanilla call and put options.
Exotic options as a rule trade in the over-the-counter (OTC) market. The OTC marketplace is a vendor representative network, instead of a large exchange, for example, the New York Stock Exchange (NYSE).
Further, the underlying asset for an exotic can vary greatly from that of a customary option. Exotic options can be utilized in trading commodities like timber, corn, oil, and natural gas as well as equities, bonds, and foreign exchange. Speculative investors might wager on the weather or price bearing of an asset using a binary option.
In spite of their embedded complexities, exotic options enjoy certain upper hands over traditional options, which can include:
- Tweaked to specific risk-management necessities of investors
- A wide assortment of investment products to meet investors' portfolio needs
- At times, lower premiums than customary options
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As you might imagine, there are many types of exotic options accessible. The risk to reward horizon traverses everything from highly speculative to more conservative. Below are several of the most common types you might see.
Chooser Options
Chooser options permit an investor to pick whether the option is a put or call during a certain point in the option's life. Both the strike price and the expiration are typically something very similar, whether it is a put or call. Chooser options are utilized by investors when there may be an event, for example, earnings or a product release that could lead to volatility or price changes in the asset price.
Compound Options
Compound options are options that give the owner the right — not commitment — to buy another option at a specific price on or by a specific date. Typically, the underlying asset of a traditional call or put option is an equity security. Nonetheless, the underlying asset of a compound option is another option. Compound options come in four types:
- Call ready to come in case of an emergency
- Call on put
- Put on put
- Put available for potential emergencies
These types of options are commonly utilized in foreign exchange and fixed-income markets.
Barrier Options
Barrier options are like plain vanilla calls and puts, yet possibly become enacted or extinguished when the underlying asset hits a preset price level. In this sense, the value of barrier options bounces up or down in leaps, instead of changing price in small increments. These options are commonly traded in the foreign exchange and equity markets.
For instance, let's say a barrier option has a knock-out price of $100 and a strike price of $90, with the stock presently trading at $80 per share. The option will act like a standard option when the underlying is below $99.99, however when the underlying stock price hits $100, the option gets knocked out and becomes worthless.
A knock-in would be the inverse. Assuming that the underlying is below $99.99, the option doesn't exist, however when the underlying hits $100, the option appears and is $10 in the money (ITM).
Barrier options can be utilized by investors to bring down the premium for buying an option. For instance, a knock-out feature for a call option could limit the gains on the underlying stock. There are four types of barrier options:
- Up-and-out is the point at which the price of the asset rises and knocks out the option
- Down-and-out is the point at which the price declines and knocks out the option
- Up-and-in initiates an option when the price rises to a specific level
- Down-and-in knocks in on a price decline
Binary Options
A binary option, or digital option, pays a fixed amount provided that an event or price movement has happened. Binary options give a win big or bust payout structure. Dissimilar to traditional call options, in which final payouts increase incrementally with each rise in the underlying asset price over the strike, binaries pay a finite lump sum in the event that the asset is over the strike. On the other hand, a buyer of a binary put option is paid the finite lump sum on the off chance that the asset closes below the stated strike price.
For instance, in the event that a trader buys a binary call option with a stated payout of $10 at the strike price of $50 and the stock price is over the strike at expiration, the holder will receive a lump-sum payout of $10 paying little mind to how high the price has risen. Assuming that the stock price is below the strike at expiration, the trader is paid nothing, and the loss is limited to the upfront premium.
Other than equities, investors can utilize binary options to trade foreign currencies like the euro (EUR) and the Canadian dollar (CAD), or commodities like crude oil and natural gas. Binary options can likewise be founded on the outcomes of events, for example, the level of the Consumer Price Index (CPI) or the value of the gross domestic product (GDP). Early exercise may not be imaginable with binaries on the off chance that the underlying conditions have not been met.
Bermuda Options
Bermuda options can be exercised at preset dates as well as the expiry date. Bermuda options could permit an investor to exercise the option just on the first of the month, for instance.
Bermuda options furnish investors with more control over when the option is exercised. This additional flexibility means a higher premium as compared to European-style options, which must be exercised on their expiration dates. In any case, Bermuda options are a less expensive alternative than American-style options, which permit exercising whenever.
Quantity-Adjusting Options
Quantity-adjusting options, called "quanto-options" for short, open the buyer to foreign assets however give the safety of a fixed exchange rate in the buyer's home currency. This option is great for an investor looking to gain exposure in foreign markets, yet who might be stressed over how exchange rates will trade when it comes time to settle the option.
For instance, a French investor looking at Brazil might find a great economic situation on the horizon and choose to put some portion of allocated capital in the BOVESPA Index, which is the largest stock exchange in Brazil. Notwithstanding, the investor is worried about how the exchange rate for the euro and Brazilian real (BRL) could trade in the interim.
Typically, the investor would have to switch euros over completely to Brazilian real to invest in the BOVESPA. Likewise, withdrawing the investment from Brazil would require converting back to euros. Accordingly, any gain in the index may be cleared out should the exchange rate move adversely.
The investor could purchase a quantity-adjusting call option on the BOVESPA denominated in euros. This solution gives the investor exposure to the BOVESPA and lets the payout remain denominated in euros. As a two-in-one package, this option will inherently demand an extra premium that is far in excess of a traditional call option's expectation's.
Think Back Options
Think back options don't have a fixed exercise price toward the beginning. Instead, the strike price resets to the best price of the underlying asset as it changes. The holder of a think back option can pick the most ideal exercise price retrospectively for the period of the option. Look-backs eliminate the risk associated with timing market entry and are typically more costly than plain vanilla options.
For instance, say an investor buys a one-month think back call option on a stock toward the beginning of the month. The exercise price is chosen at maturity by taking the most reduced price accomplished during the life of the option. Assuming the underlying is at $106 at expiration and the most minimal price during the life of the option was $71, the payoff is $35 ($106 - $71 = $35).
The risk to look-backs is the point at which an investor pays the more costly premium than a traditional option, and the stock price doesn't move to the point of generating a profit.
Asian Options
Asian options take the average price of the underlying asset to determine in the event that there is a profit as compared to the strike price. For instance, an Asian call option could take the average price for 30 days. On the off chance that the average is not exactly the strike price at expiration, the option lapses worthless.
Basket Options
Basket options are like plain vanilla options aside from that they depend on more than one underlying. For instance, an option that pays out in view of the price movement of not one however three underlying assets is a type of basket option. The underlying assets can have equivalent loads in the basket or various loads, in view of the qualities of the option.
A drawback to basket options can be that the price of the option probably won't correspond or trade in similar way as the individual parts would to price variances or the time remaining until expiration.
Extendible Options
Extendible options permit the investor to expand the expiration date of the option. As the option arrives at its expiration date, extendable options have a specific period that the option can be extended. The feature is accessible for the two buyers or sellers of extendable options and can be useful in the event that the option isn't yet profitable or out of the money (OTM) at its expiry.
Spread Options
The underlying asset for spread options is the spread or difference between the prices of two underlying assets. For instance, say a one-month spread call option has a strike price of $3 and uses the price difference between stocks ABC and XYZ as the underlying. At expiry, assuming stocks ABC and XYZ are trading at $106 and $98, individually, the option will pay $5 ($106 - $98 - $3 = $5).
Shout Options
A shout option permits the holder to lock in a certain amount in profit while retaining future upside expected on the position.
In the event that a trader buys a shout call option with a strike price of $100 on stock ABC for one month, when the stock price goes to $118, the holder of the shout option can lock in this price and have a guaranteed profit of $18. At expiry, assuming that the underlying stock goes to $125, the option pays $25. In the interim, if the stock closures at $106 at expiry, the holder actually receives $18 on the position.
Range Options
Range options have a payoff in view of the difference between the maximum and minimum price of the underlying asset during the life of the option. These options eliminate the risks associated with the entry and leave timing, making them more costly than plain vanilla and think back options.
Why Trade Exotic Options?
Exotic options have unique underlying conditions that make them a solid match for high-level active portfolio management and situation-specific solutions. Complex pricing of these derivatives might lead to arbitrage, which can give great opportunities to refined quantitative investors. Arbitrage is the simultaneous purchase and sale of an asset to take advantage of the price differences of financial instruments.
In many cases, an exotic option can be purchased for a smaller premium than a comparable vanilla option. The lower costs are frequently due to the extra features that increase the possibilities of the option expiring worthless.
Notwithstanding, there are exotic-style options that are more costly than their traditional counterparts, such as, chooser options. Here, the "decision" increases the possibilities of the option closing ITM. Albeit the chooser might be more costly than a single vanilla option, it very well may be less expensive than buying both a vanilla call and put in the event that a big move is expected, however the trader is uncertain of the course.
Exotic options may likewise be suitable for companies that need to hedge up to or down to specific price levels in the underlying asset. Hedging involves placing an offsetting position or investment to offset adverse price movements in a security or portfolio. For instance, barrier options can be an effective hedging device since they appear or leave presence at specific barrier price levels.
Exotic Option Example
Say an investor claims equity shares in Apple Inc. The investor purchased the stock at $150 per share and needs to safeguard the position in case the stock's price falls. The investor buys a Bermuda-style put option that terminates in 90 days, with a strike price of $150. The option premium costs $2, or $200 since one option contract equals 100 shares.
The option safeguards the stock position from a lessening in price below $150 for the next 90 days. In any case, this Bermuda option has an exotic feature, allowing the investor to exercise from the beginning the first of every month until expiry.
The stock price declines to $100 in month one, and by the main day of the option's subsequent month, the investor exercises the put option. The investor sells the shares of Apple at $100 per share. Nonetheless, the strike price of $150 for the put option pays the investor a $50 gain. The investor has left the overall position, including the stock position and put option, for $150 minus the $2 premium paid for the put.
Assuming Apple's stock price rose after the option was exercised in month two, say to $200 by the option's expiration date, the investor would have passed up the profits by selling the position in month two.
Albeit exotic options give flexibility and customization, they don't guarantee that the investor's decisions and choices of which strike price, expiration date, or whether to exercise early or not will be right or profitable.
Highlights
- Exotic options are options contracts that vary from traditional options in their payment structures, expiration dates, and strike prices.
- Albeit exotic options give flexibility, they don't guarantee profits.
- Exotic options can be tweaked to meet the risk tolerance and wanted profit of the investor.
