Exotic Options
Financial derivatives instruments that enable investment banks and retail investors to negotiate standard products
What Are Exotic Options?
Exotic options are financial derivatives instruments that enable investment banks and retail investors to negotiate standard products with additional features determining their benefits, such as:
- Equities
- Commodities
- Currencies
These options are more complex than the usual vanilla option, and they may also contain non-standard underlying instruments designed for specific clients or markets.
They are more complex than exchange-traded options, typically traded over the counter (OTC), and can have multiple triggers for payouts.
Exotic options are variations of the most common options contracts American and European.They differ from regular options in terms of:
- Expiration date
- Strike price
- Dividend payout
- Underlying asset
These features have the power to make the pricing of such options more challenging and uncertain when compared to vanilla options.
A pure call or put option, whether American or European, will be considered a non-exotic or ordinary option. There are two general types of exotic options: path-independent and path-dependent.
An option is a path independent if its value depends only on the final price of the underlying asset. Path-dependent options are determined not only on the final cost of the underlying asset but also on all fees that lead to the final price
Key Takeaways
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Exotic options are more complex than the standard vanilla options that are usually traded. They contain non-standard underlying instruments designed for specific clients or markets.
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Exotic options differ from regular options regarding expiration date, strike price, dividend payout, and underlying asset.
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A pure call or put option will be considered a non-exotic or ordinary option. There are two general types of exotic options: path-independent and path-dependent.
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Exotic contracts are not traded in large exchanges but the counter (OTC) market.
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The most common options are Asian, barrier, basket, Bermuda, binary, chooser, compound, extendible, lookback, quantity-adjusting, spread, shout, and range.
Types of exotic options
Since investors have many different needs, there are several kinds of existing exotic contracts. This wide variety of financial products is excellent for investors whose portfolios can achieve significant diversification.
The high-risk-high-reward framework of some options, such as Asian, barrier, or binary, makes them very likely to become worthless at maturity because the circumstances related to their success are relatively unlikely.
Other options, like a basket, Bermuda, chooser, extendible, lookback, or shout, which are relatively less rewarded than the others mentioned before, give traders more control over the option and leverage risks related to portfolio diversification or timing the market correctly.
The riskier options mentioned above are cheaper than others because of their low chances of assuring profits to investors and their lack of control over the option. Such contracts are suited for traders inclined to have high-risk assets in their portfolios.
Exotic options usually are categorized based on their unique strike price, payoff, time to maturity, exercise date, or how they react to changes in the market. Since there are unlimited ways to tailor options based on individual needs, we will look at some of the most commonly used types of option contracts.
Asian Options
Asian options are among the most common options. Their payoffs are based on the average price of the underlying security over a certain period if there is a profit with the strike price.
This is the first exotic contract ever created. It was first linked to the average price of crude oil, called the “Asian option” because the bankers who developed it were in Asia when they invented it.
Example: Considering an Asian call option with the average price for 60 days. If the average is less than the strike price at the end of the period, the option expires, and the investor doesn’t make a profit.
Barrier Options
Barrier options are similar to vanilla options. However, they are activated only when the underlying asset reaches a predetermined price level. Such options are traded in foreign exchange and equity markets.
There are four types of barrier options:
- Up-and-out, when the price increases and knocks out the option;
- Down-and-out, when the price goes down and knocks out the option;
- Up-and-in starts as an option when the price increases to a certain level;
- Down-and-in knocks in on a price decline.
Example: Consider a barrier option with a knock-in price of $150, and a strike price of $130, and each share is traded at $120.
In this case, the option will work like a normal one if the underlying is below $149.99. If the price hits $150, it gets knocked out. Oppositely, a knock-in option doesn’t exist if the underlying is under $149.99. Once it goes to $150, the option starts to live.
Basket Options
Basket options work similarly to vanilla ones, with the exception that they are constructed on more than only one underlying. The payoff is a weighted average of all underlying securities.
Example: An option that pays in compliance with the price oscillations of four assets is a basket option. Note that the weights of the underlying assets might be subject to changes in compliance with different features of the option.
Bermuda options
Bermuda options can be exercised either during predetermined dates or their expiration. These options give investors more control over the option when exercised.
They are considered a cheaper choice compared to American options, which can be exercised whenever investors want, and more flexible than European options, which are exercised only upon expiration.
Binary Options
Binary or digital options are notorious for their “all or nothing” framework. They have guaranteed payouts if a particular event occurs.
Once this event happens, the investor will get the predetermined amount or asset. On the other hand, if the event doesn’t happen, there will be no payoff, leaving the investor with nothing.
Contrary to traditional options, in which payoffs increase or decrease incrementally with underlying asset’s price fluctuation, the yield is permanently fixed in this case.
Example: An investor buys a binary put option with a fixed payoff of $20 at the strike price of $35. If the price is below the strike price at expiration, the investor will receive the $20 payoff. No payoff will be paid if the price is above the strike at the end.
Chooser Options
Chooser options allow the investor to decide whether the option is a put or a call for a determined time throughout its whole duration.
These contracts help investors when certain events could make the asset price volatile. Usually, the strike price and expiration are usually the same for both put and call.
Compound Options
Compound options allow investors to buy another for a determined price or within a defined date.
These options are used in fixed-income and foreign exchange markets. Usually, the underlying asset is an option, with the payoff being dependent on the payment reward of another option. This is why they have two strike prices and two expiration dates.
There are essentially four kinds of compound options:
- Call on call
- Call on put
- Put on put
- Put on call
Extendible options
With an extendible option, the investor has the right to postpone its expiration date, whether the investor is a buyer or seller.
This feature is beneficial when the option is not profitable or out of the money at its first expiration date, giving another chance to receive a payoff.
Lookback options
Lookback options give the owner the right to choose, at its expiration date, the best strike price during the option's duration. These options help investors eliminate the risks given by the market entry timing. They are usually more expensive than traditional options for this reason.
Lookback options don’t have a specific strike price. Because it is chosen upon maturity, the payout will differ between the current underlying and the strike price.
The risk associated with lookback options is that if the equity price doesn’t fluctuate enough, there will not be enough profit to cover the initial expense of buying such an option.
Example: An investor buys a three-month lookback call option, with the strike price being the lowest price of that equity upon maturity. Considering the underlying asset is currently at $200, and the lowest price (strike price, in this case) was $130, the payout will be $70.
Quantity-adjusting options or Quanto-options
These provide less risk to investors interested in gaining exposure to foreign markets by providing a fixed exchange rate in the investor’s main currency. By doing so, such options eliminate the risk connected to possible low exchange rates at maturity.
Shout options
Shout options give investors the right to keep a determined amount of profit and retain future upside potential on the position. The issue with such options is that, sometimes, the profit generated will not be enough to cover the expenditure of buying the contract.
Example: An investor buys a shout call option with a strike price of $160 on a particular stock for one month. If the stock goes to $188, the investor can lock the price and have a $28 profit.
At maturity, if the underlying goes to $195, the investor will have $35 of profit. On the other hand, if the price is $180, the investor will have $28 of profit, which was locked previously.
Range options
Range options' main feature is how their payouts are generated. They are formed with the spread between the highest and lowest price of the underlying asset throughout its duration.
These options take out the risk related to entry and exit timing. This feature makes them more expensive compared to vanilla and lookback options.
Exotic vs. Vanilla Options
Exotic options are generally more complex than traditional vanilla call or put options. As we have previously seen, exotic options can change depending on when the contract can be exercised or how the payout is composed.
The underlying asset of an exotic contract can vary from a regular one because it can be used in trading different financial products, from equities and bonds to commodities and foreign exchange.
Exotic contracts are not traded in large exchanges such as the NASDAQ, the New York Stock Exchange, or the Deutsche Börse, but the so-called over-the-counter (OTC) market, in which equities are negotiated thanks to a broker-dealer relationship.
It is usual to find exotic contracts cheaper than vanilla options because certain features enable them to end without the investor receiving the payout.
Nonetheless, some other exotic options are more expensive than vanilla options because the trader receives the rights to very advantageous conditions, which increase the likelihood of making profits.
Advantages Vs. Disadvantages of exotic options
Exotic options have peculiar underlying conditions, making them highly suitable for certain designed situations and active portfolio management.
Notwithstanding the high level of complexity, exotic options have several advantages that might convince investors to choose them over traditional options.
Among the advantages we can consider:
- Possibility to help offset risk in a portfolio;
- High level of customization for the investor based on the desired profit and the level of risk management;
- Investors can choose from a great variety of financial instruments to better diversify their portfolios;
- Some exotic options are cheaper than regular options.
On the other hand, it is necessary to analyze their cons to have a broad overview:
- The increased costs related to some advantageous features can make it less likely to have profits;
- The reaction of exotic options to specific events differs from traditional options.
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