Bermuda Option

What is a 'Bermuda Option'

A Bermuda option is a type of exotic option that can be exercised only on predetermined dates, typically every month. Bermuda options are a combination of American and European options; they are exercisable at the date of expiration, and on certain specified dates that occur between the purchase date and the date of expiration.

BREAKING DOWN 'Bermuda Option'

American options are exercisable any time between the purchase date and the date of expiration. European options, conversely, are exercised only at the date of expiration. Bermuda options are a hybrid security because they fall somewhere in the middle of European and American options. Other exotic options include binary options and quantity-adjusting options, often called quanto options for short.

What Are Options?

Options are financial derivatives. This means that they derive their value from another underlying asset, typically a stock. The option gives the buyer the right, but not the obligation, to buy or sell a security at a particular price on or before a specified date in the future. An option to buy a security is referred to as a call option. An option to sell a security is referred to as a put option.

For example, if you own stock in company A and want to purchase insurance against a drop in price of company A, you can purchase the option to sell the stock at a certain price, which creates a floor in terms of potential loss to the investor. The holder of the option has a certain amount of time to use the option before it expires. It can only be used or exercised if the price of the underlying stock hits the price of the option, referred to as the strike price. For this reason, the strike price and the time to expiration are two of the most important variables in option pricing.

Bermuda Options: Advantages & Disadvantages

There are several advantages and disadvantages with Bermuda options. Unlike American and European options, Bermuda options give writers and buyers the ability to create and purchase a hybrid contract. Writers of Bermuda options are given more control over when the options can be exercised. Buyers of Bermuda options are given an option that is less expensive than an American option, and less restrictive than a European option. Due to the flexibility afforded buyers, European options cost less than American options. Likewise, Bermuda options are typically less expensive than American options, because of the larger premium that American options demand from their flexibility. In other words, there's a greater chance that the option hits its strike price if the holder can exercise at any time, which makes the American option more expensive and more likely to be exercised.