Exotic Option: Definition and Comparison to Traditional Options

What Is an Exotic Option?

Exotic options are a category of options contracts that differ from traditional options of their payment structures, expiration dates, and strike prices. The underlying asset or security can vary with exotic options allowing for more investment alternatives. Exotic options are hybrid securities which are often customizable to the needs of the investor.

Key Takeaways

  • Exotic options are options contracts that differ from traditional options of their payment structures, expiration dates, and strike prices.
  • Exotic options might be customized to fulfill the danger tolerance and desired profit of the investor.
  • Although exotic options provide flexibility, they don’t guarantee profits.

Understanding Exotic Options

Exotic options are a variation of the American and European style options—probably the most common options contracts available. American options let the holder exercise their rights at any time before or on the expiration date. European options have less flexibility, only allowing the holder to exercise on the expiration date of the contracts. Exotic options are hybrids of American and European options and can often fall somewhere in between these other two styles.

A conventional options contract gives a holder a alternative or right to purchase or sell the underlying asset at a longtime price before or on the expiration date. These contracts don’t obligate the holder to transact the trade.

The investor has the proper to purchase the underlying security with a call option, while a put option provides them the power to sell the underlying security. The method where an option converts to shares is known as exercising, and the value at which it converts is the strike price.

Exotic Option vs. Traditional Option

An exotic option can vary by way of how the payoff is set and when the choice might be exercised. These options are generally more complex than plain vanilla call and put options.

Exotic options often trade within the over-the-counter (OTC) market. The OTC marketplace is a dealer-broker network, versus a big exchange resembling the Latest York Stock Exchange (NYSE).

Further, the underlying asset for an exotic can differ greatly from that of a daily option. Exotic options might be utilized in trading commodities resembling lumber, corn, oil, and natural gas in addition to equities, bonds, and foreign exchange. Speculative investors may even bet on the weather or price direction of an asset using a binary option.

Despite their embedded complexities, exotic options have certain benefits over traditional options, which may include: 

  • Customized to specific risk-management needs of investors
  • A wide range of investment products to fulfill investors’ portfolio needs
  • In some cases, lower premiums than regular options
Pros

  • Exotic options often have lower premiums than the more-flexible American options.

  • Exotic options might be customized to fulfill the danger tolerance and desired profit of the investor.

  • Exotic options might help offset risk in a portfolio.

Cons

  • Some exotic options can have increased costs given their added features.

  • Exotic options don’t guarantee a profit.

  • The response of price moves for exotics to market events might be different than traditional options.

Sorts of Exotic Options

As it’s possible you’ll imagine, there are various forms of exotic options available. The danger to reward horizon spans every little thing from highly speculative to more conservative. Below are several of probably the most common types it’s possible you’ll see.

Chooser Options

Chooser options allow an investor to decide on whether the choice is a put or call during a certain point in the choice’s life. Each the strike price and the expiration are often the identical, whether it’s a put or call. Chooser options are utilized by investors when there is perhaps an event resembling earnings or a product release that could lead on to volatility or price fluctuations within the asset price.

Compound Options

Compound options are options that give the owner the right—not obligation—to purchase an alternative choice at a selected price on or by a selected date. Typically, the underlying asset of a standard call or put option is an equity security. Nonetheless, the underlying asset of a compound option is an alternative choice. Compound options are available 4 types:

  1. Call on call
  2. Call on put
  3. Placed on put
  4. Placed on call

These kinds of options are commonly utilized in foreign exchange and fixed-income markets.

Barrier Options

Barrier options are much like plain vanilla calls and puts, but only change into activated or extinguished when the underlying asset hits a preset price level. On this sense, the worth of barrier options jumps up or down in leaps, as a substitute of fixing price in small increments. These options are commonly traded within the foreign exchange and equity markets.

For instance, to illustrate a barrier option has a knock-out price of $100 and a strike price of $90, with the stock currently trading at $80 per share. The choice will behave like a normal option when the underlying is below $99.99, but once the underlying stock price hits $100, the choice gets knocked out and becomes worthless.

A knock-in could be the alternative. If the underlying is below $99.99, the choice doesn’t exist, but once the underlying hits $100, the choice comes into existence and is $10 in the cash (ITM).

Barrier options might be utilized by investors to lower the premium for purchasing an option. For instance, a knock-out feature for a call option might limit the gains on the underlying stock. There are 4 forms of barrier options:

  1. Up-and-out is when the value of the asset rises and knocks out the choice
  2. Down-and-out is when the value declines and knocks out the choice
  3. Up-and-in initiates an option when the value rises to a selected level
  4. Down-and-in knocks in on a price decline

Binary Options

A binary option, or digital option, pays a set amount provided that an event or price movement has occurred. Binary options provide an all-or-nothing payout structure. Unlike traditional call options, wherein final payouts increase incrementally with each rise within the underlying asset price above the strike, binaries pay a finite lump sum if the asset is above the strike. Conversely, a buyer of a binary put option is paid the finite lump sum if the asset closes below the stated strike price.

For instance, if a trader buys a binary call option with a stated payout of $10 on the strike price of $50 and the stock price is above the strike at expiration, the holder will receive a lump-sum payout of $10 no matter how high the value has risen. If the stock price is below the strike at expiration, the trader is paid nothing, and the loss is proscribed to the upfront premium.

Besides equities, investors can use binary options to trade foreign exchange resembling the euro (EUR) and the Canadian dollar (CAD), or commodities resembling crude oil and natural gas. Binary options may also be based on the outcomes of events resembling the extent of the Consumer Price Index (CPI) or the worth of the gross domestic product (GDP). Early exercise will not be possible with binaries if the underlying conditions haven’t been met.

Bermuda Options

Bermuda options might be exercised at preset dates in addition to the expiry date. Bermuda options might allow an investor to exercise the choice only on the primary of the month, for instance.

Bermuda options provide investors with more control over when the choice is exercised. This added flexibility translates to the next premium as in comparison with European-style options, which may only be exercised on their expiration dates. Nonetheless, Bermuda options are a less expensive alternative than American-style options, which permit exercising at any time.

Quantity-Adjusting Options

Quantity-adjusting options, called “quanto-options” for brief, expose the client to foreign assets but provide the security of a set exchange rate in the client’s home currency. This feature is great for an investor seeking to gain exposure in foreign markets, but who could also be apprehensive about how exchange rates will trade when it comes time to settle the choice.

For instance, a French investor Brazil may find a positive economic situation on the horizon and choose to place some portion of allocated capital within the BOVESPA Index, which is the biggest stock exchange in Brazil. Nonetheless, the investor is worried about how the exchange rate for the euro and Brazilian real (BRL) might trade within the interim.

Typically, the investor would want to convert euros to Brazilian real to speculate within the BOVESPA. Also, withdrawing the investment from Brazil would require converting back to euros. Consequently, any gain within the index is perhaps worn out should the exchange rate move adversely.

The investor could purchase a quantity-adjusting call option on the BOVESPA denominated in euros. This solution provides the investor with exposure to the BOVESPA and lets the payout remain denominated in euros. As a two-in-one package, this selection will inherently demand an extra premium that’s above and beyond what a standard call option would require.

Look-Back Options

Look-back options shouldn’t have a set exercise price at first. As an alternative, the strike price resets to the most effective price of the underlying asset because it changes. The holder of a look-back option can select probably the most favorable exercise price retrospectively for the period of the choice. Look-backs eliminate the danger related to timing market entry and are typically costlier than plain vanilla options.

For instance, say an investor buys a one-month look-back call option on a stock at first of the month. The exercise price is determined at maturity by taking the bottom price achieved in the course of the lifetime of the choice. If the underlying is at $106 at expiration and the bottom price in the course of the lifetime of the choice was $71, the payoff is $35 ($106 – $71 = $35).

The danger to look-backs is when an investor pays the costlier premium than a standard option, and the stock price doesn’t move enough to generate a profit.

Asian Options

Asian options take the typical price of the underlying asset to find out if there’s a profit as in comparison with the strike price. For instance, an Asian call option might take the typical price for 30 days. If the typical is lower than the strike price at expiration, the choice expires worthless.

Basket Options

Basket options are much like plain vanilla options except that they’re based on a couple of underlying. For instance, an option that pays out based on the value movement of not one but three underlying assets is a kind of basket option. The underlying assets can have equal weights within the basket or different weights, based on the characteristics of the choice.

A drawback to basket options might be that the value of the choice won’t correlate or trade in the identical manner as the person components would to cost fluctuations or the time remaining until expiration.

Extendible Options

Extendible options allow the investor to increase the expiration date of the choice. As the choice reaches its expiration date, extendable options have a selected period that the choice might be prolonged. The feature is accessible for each buyers or sellers of extendable options and might be helpful if the choice will not be yet profitable or out of the cash (OTM) at its expiry.

Spread Options

The underlying asset for spread options is the spread or difference between the costs of two underlying assets. For instance, say a one-month spread call option has a strike price of $3 and utilizes the value difference between stocks ABC and XYZ because the underlying. At expiry, if stocks ABC and XYZ are trading at $106 and $98, respectively, the choice can pay $5 ($106 – $98 – $3 = $5).

Shout Options

A shout option allows the holder to lock in a certain quantity in profit while retaining future upside potential on the position.

If 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 on this price and have a guaranteed profit of $18. At expiry, if the underlying stock goes to $125, the choice pays $25. Meanwhile, if the stock ends at $106 at expiry, the holder still receives $18 on the position.

Range Options

Range options have a payoff based on the difference between the utmost and minimum price of the underlying asset in the course of the lifetime of the choice. These options eliminate the risks related to the entry and exit timing, making them costlier than plain vanilla and look-back options.

Why Trade Exotic Options?

Exotic options have unique underlying conditions that make them a great fit for high-level energetic portfolio management and situation-specific solutions. Complex pricing of those derivatives may give rise to arbitrage, which may provide great opportunities for sophisticated quantitative investors. Arbitrage is the simultaneous purchase and sale of an asset to use the value differences of monetary instruments.

In lots of cases, an exotic option might be purchased for a smaller premium than a comparable vanilla option. The lower costs are sometimes resulting from the additional features that increase the probabilities of the choice expiring worthless.

Nonetheless, there are exotic-style options which are costlier than their traditional counterparts, resembling, for instance, chooser options. Here, the “alternative” increases the probabilities of the choice closing ITM. Although the chooser could also be costlier than a single vanilla option, it might be cheaper than buying each a vanilla call and put if an enormous move is anticipated, however the trader is unsure of the direction.

Exotic options might also be suitable for firms that must hedge as much as or all the way down to specific price levels within the underlying asset. Hedging involves placing an offsetting position or investment to offset opposed price movements in a security or portfolio. For instance, barrier options might be an efficient hedging tool because they arrive into existence or exit of existence at specific barrier price levels.

Exotic Option Example

Say an investor owns equity shares in Apple Inc. The investor purchased the stock at $150 per share and desires to guard the position in case the stock’s price falls. The investor buys a Bermuda-style put option that expires in three months, with a strike price of $150. The choice premium costs $2, or $200 since one option contract equals 100 shares.

The choice protects the stock position from a decrease in price below $150 for the following three months. Nonetheless, this Bermuda option has an exotic feature, allowing the investor to exercise early on the primary of every month until expiry.

The stock price declines to $100 in month one, and by the primary day of the choice’s second 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 exited the general position, including the stock position and put option, for $150 minus the $2 premium paid for the put.

If Apple’s stock price rose after the choice was exercised in month two, say to $200 by the choice’s expiration date, the investor would have missed out on the profits by selling the position in month two.

Although exotic options provide flexibility and customization, they do not guarantee that the investor’s decisions and decisions of which strike price, expiration date, or whether to exercise early or not can be correct or profitable.

Investopedia doesn’t provide tax, investment, or financial services and advice. The data is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and won’t be suitable for all investors. Investing involves risk, including the possible lack of principal.

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