What is an Exotic Option
An exotic option is an option that differs in structure from the more common American options or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. Exotic options are generally more complex than plain vanilla call and put options.
Breaking Down the Exotic Option
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, they are usually traded in the over-the-counter (OTC) market.
Despite their embedded complexities, exotic options have certain advantages over regular options, which include:
- Being 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, they are cheaper than regular options
Exotic Option Examples
There are many types of exotic options available. Below we wil run through some of them.
Chooser options are an instrument that allows an investor to choose whether the option is a put or call at a certain point during the option's life. Because this type of option can change over the holding period, it is not found on regular exchanges.
Compound options are options that give the owner the right, but not the obligation, to purchase another option at a specific price on or by a specific date. Typically, the underlying asset of a call or put option is an equity security, but the underlying asset of a compound option is always another option. Compound options come in four types: call on call, call on put, put on put, and put on call. These types of options are commonly used in foreign exchange and fixed-income markets.
Barrier options are similar to plain vanilla calls and puts, but only become activated or extinguished when the underlying asset hits certain price levels. In this sense, the value of barrier options jumps up or down in leaps, instead of changing in price in small increments. These options are commonly traded in the foreign exchange and equity markets. They come in four types: up-and-out, down-and-out, up-and-in, and down-and-in.
As an example, a barrier option with a knock-out price of $100 and a strike price of $90 may be written on a stock that is currently trading at $80. The option will behave like normal when the underlying is below $99.99, but once the underlying stock's price hits $100, the option gets knocked-out and becomes worthless. A knock-in would be the opposite. If the underlying is below $99.99, the option doesn't exist, but once the underlying hits $100 the option comes into existence and is $10 in the money.
A binary option, or digital option, is defined by its unique payout method. Unlike traditional call options, in which final payouts increase incrementally with each rise in the underlying asset's price above the strike, this option provides the buyer with a finite lump sum at that point and beyond. Inversely, with the buyer of a binary put option, the finite lump-sum payout is received by the buyer if the asset closes below the stated strike price.
For example, if a trader buys a binary call option with a stated payout of $10 at the strike price of $50 and the underlying asset is above the strike at expiration, the holder will receive a lump-sum payout of $10 (irrespective of how deep in the money the option is). If the underlying asset is below the strike at expiration, the trader will not receive anything.
Most traded binary options are based on the outcomes of events rather than equities. Things like the level of the Consumer Price Index or the value of Gross Domestic Product on a specific date are usually the underlyings of the option. As such, early exercise is impossible because the underlying conditions will not have been met.
Bermuda options can be exercised at the expiry date, as well as certain specified dates in between the creation and expiration of the option's life. This style of option may provide the writer with more control over when the option is exercised and provides the buyer with a slightly less expensive alternative to an American option without the restrictions of a European option (American options demand a slightly larger premium due to their "anytime" exercise feature).
Quantity-adjusting options, called quanto options for short, expose the buyer to foreign assets but provide the safety of a fixed exchange rate in the buyer's home currency. This option is great for an investor looking to gain exposure in foreign markets, but who may be worried about how exchange rates will settle when it comes time to settle the option.
For example, a French investor looking at Brazil may find a favorable economic situation on the horizon and decide to put some portion of allocated capital in the BOVESPA Index, which represents Brazil's largest stock exchange. The problem is, the French investor is a little worried about how the exchange rate for the euro and Brazilian real might settle in the interim. The solution for this French investor is to buy a quantity-adjusting call option on the BOVESPA denominated in euros. This solution provides the investor with exposure to the BOVESPA and lets the payout remain denominated in euros.
As a two-in-one package, this option will inherently demand an additional premium that is above and beyond what a traditional call option would require. This provides quantity-adjusting option writers with additional premium if they are willing to take on the additional risk of currency
Look-back 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 market entry and are, therefore, more expensive than plain vanilla options.
Let’s say an investor buys a one-month look-back call option on a stock at the beginning of month. The exercise price is decided at maturity by taking the lowest price achieved during the life of the option. If the underlying is at $106 at expiration and the lowest price achieved was $71, the payoff is $35 ($106-$71).
Asian options have a payoff based on the average price of the underlying on a few specific dates. If the average price based on those dates is less than the exercise price, the option expires out of the money.
Basket options are similar to plain vanilla options except that they 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.
Extendible options allow the investor to extend the expiration date of the option. There are 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.
The underlying asset for spread options is the spread or difference between the prices of two underlying assets. Let’s say a one-month spread call option has a strike price of $3 and the price difference between 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.
A shout option allows the holder to lock in a certain amount in profit while retaining future upside potential on the position.
If a trader buys a shout call option with a strike price of $100 on stock ABC for a one-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 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 entry and exit timing. Hence, these are more expensive than plain vanilla as well as look-back options.
Why Trade Exotic Options
Exotic options have unique underlying conditions that make them a good fit for high-level active portfolio management and situation-specific solutions. Complex pricing of these derivatives may give rise to arbitrage, which can provide great opportunities for sophisticated quantitative investors.
In many cases an exotic option can be purchased for a smaller premium than a comparable vanilla option. This is because often exotic options contain additional features that increase the chances of the option expiring worthless. This is not the case with chooser options, for example, since the "choice" actually increases the chances of the option finishing in the money. In this case, the chooser may be more expensive than a single vanilla option, but could be cheaper than buying both a vanilla call and put if a big move is expected but the trader is unsure on the direction.
Exotic options may also be suitable for business that need to hedge up to or down to specific price levels in the underlying asset. In these cases, barrier options may be effective because they come into existence or go out of existence at specific/barrier price levels.