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.

RELATED FAQS
  1. Do you have to be an expert investor to trade put options?

    Learn about investing in put options and the associated risks. Explore how options can provide risk, which is precisely defined ... Read Answer >>
  2. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  3. Are there any risks involved in trading put options through a traditional broker?

    Explore put option trading and different put option strategies. Learn the difference between traditional, online and direct ... Read Answer >>
  4. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
Related Articles
  1. Trading

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  2. Trading

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  3. Trading

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  4. Trading

    A Newbie's Guide To Reading An Options Chain

    Learning to understand the language of options chains will help you become a more informed trader.
RELATED TERMS
  1. Asian Option

    An option whose payoff depends on the average price of the underlying ...
  2. In The Money

    1. For a call option, when the option's strike price is below ...
  3. Compound Option

    A compound options is an option for which the underlying is another ...
  4. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
  5. OTC Options

    Exotic options traded on the over-the-counter market, where participants ...
  6. European Option

    An option that can only be exercised at the end of its life, ...
Hot Definitions
  1. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  2. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  3. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  4. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  5. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
  6. Agency Problem

    A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem ...
Trading Center