In the world of finance and investment, options play a crucial role in providing flexibility and risk management. While traditional options such as calls and puts are widely known, there is a fascinating subset of exotic options. These offer unique features and strategies that go beyond the standard payoff structures found in traditional options.
In this article, we will delve into the world of exotic options. We will compare them to traditional options, explore different types, and provide a practical example of trade using an exotic option.
What Are Exotic Options?
Exotic options are those options that are structured in a non-standard format. They may involve a strike price and a spot price, but the definitions of the strike price and the payoffs are not the same as a standard option.
As such, exotic options can be of various types with different structures of the contract. Hence, it is hard to put up a single definition for them. Therefore, their identity comes from how different they are from standard options contracts.
Exotic Option vs Traditional Option
First, it is important to understand the fundamental differences between exotic options and traditional options.
Traditional options, also known as plain vanilla options, are standardised contracts traded on exchanges. These options provide the buyer with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on a particular expiry date.
On the other hand, exotic options are customised contracts tailored to the specific needs and preferences of investors. Unlike traditional options, which have standardised terms, exotic options allow investors to incorporate unique features, making them more flexible and adaptable to different trading strategies. Exotic options are usually traded over-the-counter (OTC), which means they are not listed on exchanges and are subject to negotiation between the buyer and the seller.
The details of an exotic option may vary in terms of how the gains or losses are determined and when the option can be exercised. The structure of exotic options is usually more complex than the plain vanilla call and put options.
Types of Exotic Options
There are various types of exotic options, each designed to meet different investment objectives and risk profiles. Let’s explore some of the most common types:
1. Asian options
They are option contracts where the traders get paid based on the average price of the underlying security over many predetermined periods of time. The volatility of the average price is less than that of the actual spot price. Therefore, Asian options are used to reduce the impact of one-off, extreme prices in volatile markets.
2. Barrier options
These are options that become active only in a particular range of prices of the underlying asset. Barrier options are of two types –
a. Knock-in options – These options get activated only when the spot price of the underlying asset crosses a certain point or barrier, whether moving upwards (up-and-in) or downwards (down-and-in).
b. Knock-out options – These options cease to be active if the spot price crosses a certain point or barrier.
c. Basket options – These have multiple underlying assets, which can be of various types, such as stocks, commodities, currencies, etc. The spot price and strike price here are basically the weighted average of the prices of all the underlying assets.
For example, an equity index option is a basket option as it has multiple equities as a part of the basket, each with its own weight in the index. Using basket options, companies can hedge multi-currency or multi-commodity exposures.
4. Bermuda options
These are a cross between American and European options, whereby they can be exercised before the date of their expiry but only on predetermined dates between the purchase and expiration dates.
5. Binary options
These constitute a contract whereby a fixed amount will be paid to a trader if the price is simply above or below a particular point. Basically, the buyer will either receive a payment or lose out on the entire investment – there is nothing in between. Conversely, the seller will either keep the premium received or have to make the full payout.
6. Chooser options
These allow the holder to decide whether the purchased options are calls or puts. This decision can be made only on a fixed date before the date of expiry. Such options are useful when you think the market is going to be volatile, but you do not know the direction in which it will change.
7. Compound options
These are essentially an option on an option. The final payoff on the second option depends on the payoff received from the first one. Therefore, compound options have two different expiry dates and two different strike prices. Compound options are also known as split-fee options.
8. Extendible options
These contracts allow investors to postpone the expiry dates of their options. The holder-extendible options allow the option-buyer to extend the option’s expiry by a predetermined amount of time. This helps the buyer if the options are out-of-the-money. Similarly, the writer-extendible options provide the writer or issuer of the options to extend the expiry date.
9. Lookback options
These options give the holder the right to purchase or sell the underlying asset at its highest or lowest price within a specified period in the past. Therefore, the traders can choose the time when the option is the most in-the-money.
10. Spread options
The payoff of a spread option depends on the difference between the prices of two underlying assets. The assets can be two different commodities as well as the same commodity but on two different exchanges or even at different stages of production. Crack, crush and spark spread are some of the types of spread options.
11. Range options
These are similar to a binary option – their final payout is given to the holder if the price of the underlying asset stays within a particular range during the time up until the date of expiry.
An Example of Trading Exotic Options
Exotic derivatives examples help illustrate the practical application of exotic options. Let us then consider an example involving a barrier option:
Suppose a trader expects the spot price of the underlying asset to rise. But they do not want to exercise the option unless there are significant gains – it may be that they might want to invest in instruments with higher returns.
In that case, the trader can set a call option, assuming the strike price of Rs. 100 and also set up a knock-in barrier option with the barrier set at Rs. 115. Assume that the premium paid is Rs. 2. Therefore, the option may be profitable when the spot price is Rs. 103. However, the option will be activated only when the spot price crosses Rs. 115.
Options are one of the most interesting financial instruments available in the stock, commodity or currency market. Open a Demat account with Angel One and begin your options trading journey today!
Are exotic options more expensive than traditional options?
Exotic options may or may not be more expensive than traditional options. The exact cost depends on the type of exotic option.
Are exotic options suitable for all types of investors?
Exotic options are more complex and carry additional risks compared to traditional options. They are typically more suitable for experienced investors who have a deep understanding of derivatives and are willing to accept the associated complexities and risks.
Can exotic options be traded on exchanges?
Exotic options are primarily traded over-the-counter (OTC), which means they are not listed on exchanges. This is because they are customised contracts negotiated between the buyer and the seller, allowing for more flexibility in terms of contract terms and features.
What are the main advantages of using exotic options?
Exotic options offer investors the ability to customise their risk management strategies and adapt to specific market conditions. They provide unique features and payoffs that can be tailored to suit individual investment objectives.