A:

Before learning about exotic options, you should have a fairly good understanding of regular options. Both types of options share the idea of having the right to buy or sell an asset in the future, but the way investors realize profits using these options can differ dramatically.

Simply put, an exotic option is any type of option other than the standard calls and puts found on major exchanges. An investor who buys a call option has essentially bought a standardized right to purchase a specific amount of an underlying asset at the agreed upon strike price, while a put option gives the investor the right to sell the specific asset at the strike if the price of the underlying decreases. These regular options are also known as plain vanilla options. Exotic options can be quite different, as these examples show:

Chooser option
: An option that gives the investor the right to choose whether the option is a put or a call at a certain point during the option's life. Unlike regular options that are purchased as a call or a put at inception, these exotic options can change during the life of the option.

Barrier option
: A type of option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. The right to purchase the underlying at an agreed strike price only kicks in when the price hits the agreed upon 'barrier'. This is unlike a regular option because the holder of a vanilla option can buy the underlying at the strike price at any time after inception.

Asian option: Anyone who invests in regular options will attest to their volatility. Asian options are a good way to reduce this volatility. These exotic options have a payoff that depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. Also known as an average option.

The final difference between exotic options and regular options has to do with how they trade. Regular options consist of calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange. Exotic options are mainly traded over the counter, which means they are not listed on a formal exchange, and the terms of the options are generally negotiated by brokers/dealers and are not normally standardized as they are with regular options.

For further reading, see our Options Basics tutorial.

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