The exotic options are contracts that have procedural concepts similar to the traditional options. However, there is a difference between the exotic options and traditional options regarding the strike prices, the structure of the option, and the date of expiration.
These options are more customizable and can meet the investor’s risk appetite looking for the balance between the profitability and presumption of the risk. These options provide flexibility of the trade. However, the exotic options are not guaranteed to produce profits.
The options carry the same features as normal options, but there is something more complex and agreed upon between the parties in the contract.
Explanation of the exotic options
As we have discussed that exotic options lie somewhere between the variants of America and Europe. The variant of America allows an option to be exercised at any time before or on the date of the expiration. On the other hand, the European variant only allows the option to be exercised on the date of expiration. However, the exotic option is something that lies between these two variants. So, it’s a hybrid and contains characteristics of both variants. Further, these options are traded over the counter, and these are not standard options but heavily customized.
Let’s discuss different types of exotic options available in the market. It will clearly explain the hybrid concept and how it differs from the conventional options.
Types of the exotic options
There are different types of exotic options that vary in the span of the risk. Some of the options are risky and some are conservative.
The choose option is when the contract holder can choose if the contract is a put option or sale option before the expiry date. It means there is some more flexibility than the normal options trading in the market. More customization comes with more complexity of the option. Hence, the chooser option offers some more flexibility and more complexity.
The compound option is when the underlying security is another option. It means these types of options are more complex than usual/simple options. In this type of option, there are two types of strike prices. Further, the compound options can be in any permutations that include a call on call, put on put, call on put, put on call, etc. Most dealers in the fixed income markets and the foreign exchange use these options to manage their risk profile and risk exposure.
The barrier options are more or less the same as simple options. However, there is one difference that this type of option can only be exercised when the underlying asset hits the preset price. If there are small fluctuations in the underlying asset price, the barrier option cannot be exercised. Hence, it provides all payout or nothing at all.
The Bermuda option is when the right can be exercised on some preset-specific dates or at the time of the expiry. Hence, it’s more flexible than the European options that can be exercised only at the time of expiry and less flexible than American options that can be exercised at any time.
It’s important to note that more flexibility of the date of expiry cost more than less flexibility. Hence, Bermuda options are less expensive than American options that can be exercised at any time while more costly than European options as there is more date of exercise of the right.
The Quanto options/Quantity adjusting options are when an investor is optimistic about better performance of the foreign market and at the same time pessimistic about the movement of the rate of interest. In other words, the investor thinks that his investment in a foreign market will perform and produce a profit. However, they believe that profit earned will be adjusted against losses on currency exchange to their local currency because their home currency is expected to be devalued.
So, in this situation, an essential role is played by the Quanto options/Quantity adjusting option that exposes the investor to the financial market while providing safety for the adverse movement of the interest rate that might impair the investor’s profitability.
The Asian option is when the payout on the option’s exercise depends on the average value of underlying assets. It’s different from typical American and European options, where the worth of the underlying asset is assessed at the time of the expiry date. This enables the trade of the underlying asset to take place on the average prices, and the relevancy of the spot price decreases.
The rate of volatility in the Asian options is limited as these options follow the average mechanism. Further, these types of options are used when the underlying asset value is highly volatile, and the average mechanism seems suitable in the situation.
Other exotic options include look-back options, basket options, extendible options, spread options, shout options, and range options, etc. All these options have the same basic theme with some customization and complexity compared to normal options available in the market. However, an investor needs to understand the appropriate situation of the usage.
The advantages of the exotic options include but are not limited to the following.
- These options are customized with a greater degree of flexibility. Hence, an investor can plan to hedge appropriately.
- The premium on these types of options is comparatively lower than American types of options.
- These options are helpful in risk management and can be used to offset the risk in a portfolio.
Following are some of the disadvantages of the exotic options.
- The premium on the exotic options can be higher as there is more customization and more flexibility.
- There is no guarantee of profit.
- It can be difficult for the investor to understand the theme in exotic options as it’s sometimes more complex.