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Exotic Options

KEY TAKEAWAYS

  • Exotic options are options contracts that vary from traditional options in their payment patterns, expiration dates, and strike rates.
  • Exotic options can be customized to satisfy the risk tolerance and desired revenue of the investor.
  • Although exotic options give flexibility, they do not safeguard gains.


What Is an Exotic Option?

Exotic options are a variety of options contracts that vary from traditional options in their payment patterns, expiration dates, and strike rates. The underlying asset or security can differ with exotic options enabling extra investment alternatives. Exotic options are mixed securities that are frequently customizable to the requirements of the investor.

Understanding Exotic Options

  • Exotic options are a variety of the American and European modes of options—the most popular options contracts available. American options allow the holder to exercise their rights at any time before or on the expiration date. European options have limited flexibility, only enabling the holder to practice on the expiration date of the contracts. Exotic options are mixtures of American and European options and will frequently fall somewhere in between these other modes.
  • A traditional options contract provides a holder a choice or right to purchase or sell the underlying asset at a formal price before or on the expiration date. These contracts do not obligate the investor to transact the trade. The investor has the right to purchase the underlying security with a call option, while a put option gives them the capacity to sell the underlying security. The procedure where an option converts to shares is termed as exercising, and the rate at which it converts is called the strike price.

Exotic Option vs. Traditional Option

An exotic option can differ in terms of how the profit is specified and when the option can be practiced. These options are commonly more tricky than plain vanilla call and put options.

Exotic options normally trade in the over-the-counter (OTC) market. The OTC marketplace is a dealer-broker network, as contradicted to a huge stock exchange such as the New York Stock Exchange (NYSE).

Despite their embedded complexness, exotic options have specific benefits over traditional options, which can comprise of :

  • Customized to definite risk-management needs of investors
  • A large variety of investment products to fulfill investors' portfolio requirements.
  • In some cases, lower premiums than conventional options

Pros

  • Exotic options usually have insufficient premiums than the more adaptable American options.
  • Exotic options can be customized to meet the risk tolerance and desired gain of the investor.
  • Exotic options can enable offset risk in a portfolio.

Cons

  • Some exotic options can have boosted expenses given their added features.
  • Exotic options do not safeguard an income.
  • The reaction of price shifts for exotics to market events can be distinct from traditional options.

Categories of Exotic Options

As you may comprehend, there are many categories of exotic options available. The risk to reward horizon ranges everything from highly risky to more conservative. Below are various of the most common categories you may see.

Options

Chooser options enable an investor to select whether the option is a put or call during a certain point in the option's life. Both the strike rate and the expiration are usually similar, whether it is a put or call. Chooser options are utilized by investors when there might be a circumstance such as earnings or a product release that could steer to volatility or price fluctuations in the asset price.



Compound Options

Compound options are options that provide the owner the right—not obligation —to purchase another option at a particular price on or by a particular date. Commonly, the underlying asset of a traditional call or put option is equity security. Still, the underlying asset of a compound option is a different option. Compound options come in 4 types:
  • Call on call
  • Call on put
  • Put on put
  • Put on call
These categories of options are generally utilized in foreign exchange and fixed-income markets.

Barrier Options

Barrier options are similar to plain vanilla calls and puts, but only become activated or demolished when the basic asset hits a pre-set rate level. In this sense, the value of barrier options jumps up or down in hops, rather than altering prices in minor increments. These options are normally traded in the foreign exchange and equity markets.

Bermuda Options

Bermuda options can be practiced at pre-set dates as well as the expiry date. Bermuda options might enable an investor to practice the option only on the first of the month, for instance.

Bermuda options give investors more supervision over when the option is practiced. This added flexibility translates to a higher premium as distinguished to European-style options, which can only be practiced on their expiration dates. Still, Bermuda options are a cheaper alternative than American-style options, which enable practicing at any time.

Why Trade Exotic Options?

Exotic options have extraordinary underlying conditions that make them a promising fit for high-level active portfolio management and situation-specific solutions. Complex pricing of these derivatives may provide growth to arbitrage, which can give tremendous opportunities for experienced quantitative investors. Arbitrage is the concurrent purchase and sale of an asset to influence the price disparities of financial instruments.

Conclusion

Although exotic options give flexibility and customization, they don't safeguard that the investor's options and decisions of which strike price, expiration date, or whether to exercise early or not will be accurate or successful.

In many cases, an exotic option can be bought for a smaller premium than a comparative vanilla option. The lower expenses are frequently due to the additional features that boost the chances of the option expiring as worthless.

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