What is an 'Exotic Option'

An exotic option is an option that differs in structure from common American 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 much more complex than plain vanilla options, such as calls and puts that trade on an exchange.

BREAKING DOWN 'Exotic Option'

Because of the complexity and customization of exotic options, they trade over-the-counter and there are many different types of exotic options available. One type is known as a chooser option. This instrument allows an investor to choose whether the options 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, which is why it is classified as an exotic option. Other types of exotic options include: barrier options, Asian options, digital options and compound options, among others.

Exotic Option Examples

While there are many types of exotic options available, below are details of three of the more commonly traded ones.

Compound options are options that give the owner to 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. These exotic options also come in four types: up-and-out, down-and-out, up-and-in, and down-and-in. For example, a barrier option with a knock-out price of $100 may be written on a stock that is currently trading at $80. The option will behave like normal from prices ranging from $80 to $99.99, but once the underlying stock's price hits $100, the option gets knocked-out and becomes worthless.

Chooser options give the owner a certain period of time to decide whether the option they own will become a European call option or a European put option. These types of options are generally used in the equity market, especially on indices. Chooser options are a great choice when large price fluctuations are expected in the near future, and can usually be purchased for a lower cost than a call and put option straddle.

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