What is a Bermuda Option
A Bermuda option is a type of exotic option that can only be exercised on predetermined dates, often on one day each month. Bermuda options are a combination of American and European options. The Bermuda is exercisable at the date of expiration, and on certain specified dates that occur between the purchase date and the date of expiration.
Breaking Down the Bermuda Option
Bermuda options are a fusion between American and European options. American options are exercisable at any time between the purchase date and the date of expiration. European options are exercised only at the date of expiration. Bermuda options are a hybrid security because they fall somewhere in the middle of these two types. 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, such as a stock. The option gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a particular price on or before a specified date in the future. An option to buy an underlying asset is referred to as a call option. An option to sell an underlying asset 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 the price of Company A, you can purchase a put option to sell the stock at a certain price, which creates a floor in terms of potential losses. The holder of the option has a certain amount of time to use the option before it expires.
Say a trader has purchased Company A's stock at $50. They believe the stock will rise over time, so they want to hold onto the stock, but don't want to lose money if the stock drops in the short-term. They buy a put option that expires in three months, with a strike price of $45. The option costs $3, or $300 since each option contract represents 100 shares. This option protects the buyer from drops below $45 for the next three months. If it is a Bermuda option, and the buyer decides to exercise the option—that is, to sell the stock at $45 if the stock has fallen below that—they will only be able to it on exercise dates outlined in the contract.
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 their more restrictive nature, 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. Therefore, Bermuda options are a compromise between these other two styles. They offer mid-range flexibility for a mid-range price, comparatively.