Exotic options are options contracts with payment structures, expiration dates, and strike prices that differ from traditional ones.
Exotic options give you extra investing opportunities by varying the underlying asset or security. They are a type of hybrid security that can be tailored to the investor’s demands.
What Are Exotic Options?
Exotic options are a variation of the most typical options contracts, which are American and European style options.
The holder of an American option can execute their rights at any time before or after the expiration date. European options are less flexible, allowing the holder to execute only on the contract’s expiration date. Exotic options are a mix of American and European ones, usually somewhere in the middle.
With a call option, the investor has the choice to buy the underlying security. Whereas with a put option, the investor has the option to sell the underlying security. Exercising is the process of converting an option into shares, and the strike price is the price at which it converts.
Exotic VS. Traditional Options
The payoff of an exotic option might differ depending on how it is calculated and when it can be executed. These options are typically more complicated than plain vanilla call and put options.
Exotic options are often traded in the over-the-counter (OTC) market. In contrast to a major exchange like the New York Stock Exchange (NYSE), the OTC marketplace is a dealer-broker network. Furthermore, the underlying asset for an exotic option can differ significantly from that of a traditional option.
Exotic options can be used to trade commodities such as lumber, corn, oil, and natural gas, as well as stocks, bonds, and forex. Speculative investors can even use binary options to bet on an asset’s weather or price direction. Exotic options, despite their inherent complexities, offer significant benefits, which might include:
- Customized to investors’ unique risk-management requirements
- A diverse range of investment options to fulfill the demands of investors’ needs
- Lower rates than traditional options
Types of Exotic Options
There are 11 types of exotic options that we will explain below.
Barrier Option
A Barrier Option is a form of derivative option contract whose payoff is based on the underlying asset’s value. In other words, the payoff is only activated if the asset underlying the Barrier option has reached or surpassed the option contract’s set price.
Suppose the price of the underlying asset exceeds a specific price. In that case, a Barrier option can expire worthless (knock-out option), limiting profit for the option holder and losses for the option writer (seller).
Bermuda Option
Bermuda options can be exercised at certain times and on their expiration dates. For example, these options can only allow an investor to execute the option on the first of the month.
Investors with the Bermuda option have more flexibility when the option is exercised. When compared to European-style options, which can only be used on their expiration dates, this extra flexibility translates to a greater price. On the other hand, Bermuda options are less expensive than American-style options, allowing you to exercise anytime.
Asian Option
To evaluate if there is a profit when compared to the strike price, Asian options use the underlying asset’s average price. An Asian call option might use the 30-day average price. The option expires worthless if the average is less than the strike price at expiration.
Range Option
The payment is determined by the difference between the underlying asset’s highest and lowest price throughout the option’s life. Range options are more expensive than plain vanilla and look-back options because they reduce the risks associated with the time of entry and exit.
Spread Option
Unlike a traditional option, a spread option rewards an investor depending on the price difference between several assets when the investor executes the contract.
Chooser Option
Ordinary options contracts require the investor to choose whether to buy a call or a put option up front. A chooser option, on the other hand, allows the holder to decide whether the option will be a put or call option at a set date between when they buy the chooser option and when the contract expires.
Basket Option
Basket options are similar to traditional options, but they depend on several underlying factors. A basket option is a type of option that pays off based on the price movement of not one but three underlying assets.
Look-back Option
There is no set execution price for look-back options at the beginning. Instead, as the underlying asset’s price changes, the strike price is updated to the best price available. For the option’s duration, the holder of a look-back option can retrospectively pick the most advantageous exercise price. Look-backs are more expensive than simple vanilla options since they reduce the risk of timing market entry.
Compound Option
Investors can buy an option on an option with compound options, which are also known as split-fee options. A compound option’s success depends on another option’s success.
Extendible Option
The main benefit of extendible options is that they allow an investor to postpone the contract’s expiration date for a certain period of time. This might imply extending the time for an out-of-the-money option to become profitable, a feature that was included in the original option contract. Extendible options can be holder-extendible, which means that the buyer has the opportunity to extend their options.
Binary Option
Binary options, also known as digital options, are unique because they only guarantee a payoff to the holder if a preset event occurs. If the agreed-upon event occurs, an all-or-nothing investment often yields a set payoff or asset.
Advantages and Disadvantages of Exotic Options
Advantages
- The premiums for some exotic options are cheaper than for more flexible American options contracts
- Exotic options can be selected and customized by investors to match extremely complex and precise strategies
- Exotic options allow investors to fine-tune their portfolio’s risk exposure
Disadvantages
- Many exotic options come with higher cost and less flexibility than traditional contracts
- There are no profit-guaranteed exotic options
- The complex rules mean that exotic options have a higher risk of ultimately becoming worthless
Takeaways
- Exotic options are options contracts with payment structures, expiration dates, and strike prices.
- They are often traded in the over-the-counter (OTC) market.
- There are 11 types of exotic options.
- Exotic options differ from the traditional ones by execution methods, trading markets, and usage.
- Usually, premium exotic options are cheaper than American-style options.
