Finance

Exotic Options

Exotic Options

Options are versatile financial products. Options are a type of derivative that derives their value from the value of the underlying asset. An option contract is a financial contract that gives the investor an opportunity to buy or sell an asset at a pre-determined price at a specific date. Options are of two types: call option and put option. The call option allows the investor to buy the asset and a put option allows the investor to sell the asset at a specific price on a specific date. Every options contract has an expiry date by which the holder must exercise the option.

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What are Exotic Options?

Exotic options are the class of options contracts whose structure and features are different from plain vanilla options. Exotic options are different from other options on the basis of the expiry date, exercise price, payoff, and underlying assets. Exotic options are more sophisticated and they provide a unique hedge for firms underlying assets. It is concerned with creating new securities and developing suitable pricing techniques.

Different between Plain Vanilla Options & Exotic Options:

Plain Vanilla Options Exotic Options
They are non-customized and are traded on exchanges in liquid markets. They are customized and are traded in  OTC markets.
Plain Vanilla options have low risk. Exotic options have a high risk.
Plain Vanilla options are simple and are not complex. Exotic options have complicated features.

Types of Exotic Options:

  1. Asian Options: Option contracts whose payoff is determined by the average price of the security over a period of time. It is the most encountered type of exotic option.
  1. Barrier Options: When the price of the security reaches a predetermined level, then only the contract gets activated.
  1. Basket Options: It is basically the weighted average of all the assets whose weights are not always equal.
  1. Bermuda Options: It is a combination of both American & European options. These options can be exercised either at expiry or at predetermined dates between the purchase and expiry dates.
  1. Binary Options: It has discontinuous payoff profiles as they are paid only at the expiration of the asset value is above the strike price. It guarantees payoff on the occurrence of a certain event.
  1. Chooser Options: It gives the option holder the right to decide whether the purchased options are call or put.
  1. Compound Options: Its payoff depends on the payoff of another asset which means it will 2 strike prices and 2 expiry dates.
  1. Extendible Options: It gives the right to extend the expiry dates.
  1. Lookback Options: These options do not have a specific exercise price, however, on the maturity date, the holder has the right to choose the most favorable strike price amongst the prices that occurred during the life of the option.

10.Spread Options: The payoff depends on the difference between the prices of the 2  underlying assets.

  1. Range Options: The final payoff is determined as the spread between minimum and maximum prices of assets during the life of the option.

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The risk involved in Exotic Options:

  1. Options are time-sensitive investments; hence an investor may lose out on all his investments.
  2. Due to its complex features, sometimes it becomes complicated to understand certain aspects.
  3. There are many types of options, so issues with liquidity arise with certain options as they are traded in very low volumes.
  4. The cost of trading options is very high and lack of liquidity will generally lead to bigger spreads, which is a potentially significant risk.
  5. Every option one owns, will lose its value over time so it is an unavoidable risk.

Final thoughts:

The only way to hedge the risk of an option is by taking another position in the market. An investor can use exotic options to limit or reduce his risk exposure. It is very important to understand the various types of options trading strategies and use them to gain higher returns by reducing risks.

Author: Urvi Surti

About the Author:

Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).

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