Exotic options differ from regular options in their payoff and pricing. While a regular option has a fixed expiration date and exercise price, an exotic option can vary in terms of how the payoff is determined and when the option can be exercised. Further, the underlying asset for an exotic can differ greatly from that of a regular option. For instance, an exotic option may have weather or rainfall as the underlying. As it follows, such options are often complex to price and structure. Hence, these are usually traded in the OTC markets than on an exchange. (For related reading, refer to What's the difference between a regular option and an exotic option?)

Despite their embedded complexities, exotic options have certain advantages over regular options, which include: 

  • More adaptable to specific risk management needs of individuals or entities
  • Trading and management of unique risk dimensions
  • A greater range of investment products to meet investors' portfolio needs
  • In some cases, cheaper than regular options

In this article, we explore different kinds of exotic options and look into their characteristics. Some commonly noted exotic options are:

For the purpose of illustration, we will refer to the price chart below for an imaginary stock, ABC, with daily price data over a one-month period.

 

Binary Options

Binary options, also called Digital options, have a payoff similar to digital logic of 0 and 1. These options either pay a fixed amount if the option expires in the money or pay nothing at all if it expires out of money.

Let’s say the underlying stock ABC is trading at $100 at the beginning of the month. An investor buys a Binary call option on ABC with a strike price of $100, maturity of 1 month and a payoff of $20.  At the end of the month, the underlying stock is trading at $106, and hence the option is in the money. The investor receives $20 (irrespective of how deep in the money the option is) at expiration. (For additional reading, refer to What's the difference between binary options and day trading? and Common Misconceptions About Binary Options).

Barrier Options

As the name suggests, these options pay off only when the underlying price crosses a barrier. The pay-off is, however, based on the exercise price and not the barrier price. There are two kinds of Barrier options:

Let’s assume an investor buys a 1-month Barrier call option on ABC with a knock-in at $110 and exercise price of $100 on March 2, 2015. This option becomes active only from March 23rd when the underlying goes to $118, hence, crossing the barrier of $110. At expiry, the payoff is $6. Meanwhile, if the option was a knock-out type instead, it would become worthless on March 23rd and have a payoff of $0.

Look-Back Options

These options do not have a fixed exercise price at the beginning. The holder of such an option can choose the most favorable exercise price retrospectively for the time period of the option. These options eliminate the risk associated with timing the market entry and are, therefore, more expensive than plain vanilla options.

Let’s say an investor buys a 1-month look-back call option on stock ABC at the beginning of month. The exercise price is decided at maturity by taking the lowest price achieved during the life of the option. The underlying is at $106 at expiration and lowest price achieved at $71. Therefore, the payoff is $35 (= $106 - $71).

Compound Options

These options have another option as the underlying asset.

For example, an investor can buy a 1-month compound call option that has a 3-month call option on stock ABC as the underlying. The pricing for such an option may be obtained by double application of the Black-Scholes option pricing model.

Asian Options

These options have a pay-off based on the average price of the underlying on a few specific dates.

Let’s assume an investor buys a 1-month Asian call option with a strike price of $100 on stock ABC. According to the contract, this option pays based on the average price of underlying on three days — March 10th, March 20th and March 30th. From the chart above, the average price based on these three prices is $94.67. Since this average price is less than the exercise price, the option expires out of the money.

Chooser Options

Essentially, options that let the holder decide whether it is a call or put once a predetermined date is reached are compound options.

A call on call/put is one type of chooser option [Aren't these types of compound options?]. The holder of such an option has the right to buy a call or put option (depending on their preference at the time of exercise) on an underlying stock.

Bermuda Options

These options allow early exercise only on a few specific dates. Sometimes, they have a lockout period and allow early exercise after the lockout period is over. 

For instance, an investor buys a 1-month Bermuda call option with a strike price of $100 on stock ABC at the beginning of month when the underlying is trading at $100. This Bermuda option can have a lockout period of, say, 10 days and allow early exercise (such as an American option) from then on.

Basket Options

These options are similar to plain vanilla options except that these are based on more than one underlying.

For example, an option that pays off based on the price movement of not one but three underlying assets is a type of Basket option. The underlying assets can have equal weights in the basket or different weights, based on the characteristics of the option. (For additional reading, see How do I use a "basket" option?).

Extendible Options

These options allow the investor to extend the expiration date of the option. These are of two types:

  • Holder-extendible: The buyer of the option (call or put) has the right to extend the option by a pre-specified amount of time if the option is out of the money at the original expiration date.
  • Writer-extendible: The writer of the option (call or put) has the right to extend the option by a pre-specified amount of time if the option is out of the money at the original expiration date.

Let’s say an investor buys a 1-month put option with strike price of $100 on stock ABC with an embedded extendible option at the beginning of the month. At the original expiry date (March 30th), the put option is out of the money, as ABC is trading at $106. If the holder of this option anticipates a drop in the price of ABC, he/she may extend the expiry date by paying an additional premium (as set out in the contract) to the writer.

Spread Options

The underlying asset for these options is the spread or difference between the prices of two underlying assets.

Let’s say a 1-month spread call option has a strike price of $3 and the price difference between two stocks ABC and XYZ as the underlying. At expiry, if stocks ABC and XYZ are trading at $106 and $98, respectively, the option will pay $106 - $98 - $3 = $5.

Shout Options

A shout option allows the holder to lock in a certain amount in profit while retaining future upside potential on the position.

Let’s assume that an investor buys a shout call option with a strike price of $100 on stock ABC for a 1-month period. When the stock price goes to $118, the holder of the shout option can lock in this price and have a guaranteed profit of $18. At expiry, if the underlying stock goes to $125, the option pays $25. Meanwhile, if the stock ends at $106 at expiry, the holder still receives $18 on the position.

Range Options

These options have a payoff based on the difference between the maximum and minimum price of the underlying asset during the life of the option. These options eliminate the risks associated with market entry and market exit timing. Hence, these are more expensive than plain vanilla as well as look-back options.

From the chart above, a range option for 1-month on stock ABC will have a payoff of $118 - $71 = $47.

The Bottom Line

Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. Here, we have listed some of the popular exotic options. However, this list is by no means exhaustive, as there can be an infinite number of exotic options developed by adding the characteristics of different plain vanilla options or even exotic options. The pricing for such instruments is considerably complex, and hence a majority of these are traded in OTC markets. The world of exotics continues to evolve and presents the financial community with exciting opportunities and new challenges. (For additional reading, refer to Exotic Options: A Getaway From Ordinary Trading).

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