What Is an AC-DC Option?

An AC-DC option is a derivative that, on a future date, can become a call or put option at the buyer's discretion. Also known a "chooser option" or "hermaphrodite option," it is a type of exotic option, meaning it has more complicated terms and is often more expensive, than the traditional, plain-vanilla variety.

The Basics of AC-DC Options

Like any option, the AC-DC option is a derivative that gives an investor the right – but not the obligation – to buy (call) or sell (put) a security at a certain price (the strike). Its main distinction lies in the fact that the investor makes the buy or sell decision at a specific time after the option is in force, rather than at the time of purchase.

The timing of the decision depends on how the option is constructed. Many AC-DC options are European options, meaning the buy or sell decision may be exercised only when the instrument is about to expire. American options allow a decision to be exercised any time before the expiration date.

AC-DC Option Strategies

An AC-DC option can be a very attractive instrument when an underlying security reports a high level of volatility or when there is uncertainty around corporate news or developments – like a pharmaceutical company waiting to receive Food and Drug Administration approval for an expensive new drug, a tech firm seeking exclusive rights or patents for an innovative product, or any firm involved in major litigation. It offers the option-holder the flexibility to choose the specified payoff based on whether the call or put position is more profitable.

For example, if a security is trading above its strike price at expiration then the call option exercise is generally the most profitable. If the holder chooses to exercise the option as a call option on the underlying security then the payoff would be the maximum of the spot price minus the strike price. In this scenario, the holder benefits from buying the security at a lower price than it is selling for in the market.

On the other hand, if a security is trading below its strike price at expiration then the put option exercise would generally be the most profitable. If the holder chooses to exercise his option as a put option on the underlying security then the payoff would be maximum of the strike price minus the spot price. In this scenario the holder benefits from selling the underlying security at a higher price then it is trading for in the open market.

AC-DC Option Considerations

Of course, it is this flexibility causes the AC-DC option to be pricier than its simple put or call option counterpart, even if they have the same underlying security. Generally, the more volatile the underlying security, the more expensive the AC-DC option.

Key Takeaways

  • An AC-DC option is a derivative which, on a future date, can become a call or put option at the buyer's discretion.
  • AC-DC options are often ideal instruments for investors considering highly volatile stocks, as they offer the flexibility to choose the specified payoff based on whether the call or put position is more profitable.
  • This flexibility causes the AC-DC option to be pricier than its simple put or call option counterpart.

Also, AC-DC options are generally traded on alternative exchanges without the support of regulatory oversight common to plain vanilla options that trade on major exchanges. As a result, they may carry higher risks of counterparty default.