Exotic Option 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 options 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 stocks 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. OPTIONS TRADING Exotic Options In all our articles until now we have focused on the simple put and call options also known as vanilla options and related strategies. In this last article we will focus on exotic options. Exotic options are characterized by a greater complexity than that of the commonly traded vanilla options. Vanilla options are considered simple since the payoff profile is continuous and is only dependent on the value of the underlying at expiry. Exotic options are everything else - which is a very large definition. Therefore, in this article we will only focus on the vanilla option with in and out features known as knock-in, knock-out, reverse-knock-in, and reverse-knock-out. Furthermore, we will look at the American digital option one-touch, no-touch, and double-no-touch. The knock-out option functions by being an ordinary vanilla option, put or call, unless a pre-specified barrier level is reached, or touched, before expiry. The option is termed reverse if the barrier is placed where the option is in-the-money. That is, if the barrier is above the strike for a call option or the barrier is below the strike for a put option (see Figure 1 and 2 for illustrations of the knock-out feature). The knock-in option functions by being worthless unless the barrier is touched, in which case it converts into a normal vanilla option. Again the reverse termed is used if the barrier is placed where the option is in-the-money (see Figure 3 and 4 for illustrations). Notice that holding a knock-in and knock-out based on the same barrier and vanilla option strike is the same as holding the vanilla option itself. Therefore, the price of holding a knock-in and a knock-out with the same barrier and strike should be equal to the price of the vanilla option with the same strike. It should now be obvious that the prices of the knock-in and knock-out options are expected to be lower than the vanilla option with the same strike. In this way, a purchaser of an exotic option may strive essentially to gain the same exposure to a vanilla option but at a lower price - on the condition that his prediction about whether the underlying will reach the barrier level holds true. While the purchaser of the exotic option does gain an exposure similar to the vanilla option, the pricing dynamics do change dramatically. With vanilla options, the price is always increasing with respect to the volatility parameter. However, barrier options can behave quite differently. For example, a reverse-knock-out call option with the underlying trading close to the barrier will decrease in value from an increase in volatility as the chance of hitting the barrier increases. On the other hand, the value of the same option will increase in value from an increase in the volatility, if the underlying is far from the barrier, as the increased likelihood of hitting the barrier is compensated by the increased value of the option with respect to its strike. This implies that simple gamma scalping strategies as explain in previous articles, for example, become very difficult to manage, due to the complex influence of both the strike and the barrier on the delta of the option. Therefore, knock-in, knock-out, reverse-knock-in, and reverse-knock-outrsquos are often best suited as directional option trades, as described in the article about speculative trading. Another class of exotics options are the American digitals also known as touch options. They function like bets by paying a predetermined amount if a certain condition is met. The payoff is thus the full amount or nothing, which gives rise to the term digital. The one-touch option pays out if the price of the underlying touches the barrier before expiry (see Figure 5). The no-touch option works the other way around and pays out if the price of the underlying does not touch the barrier before expiry (see Figure 6). The double-no-touch option pays out if the price of the underlying stays within a range not touching either the lower or the upper barrier of this range before expiry (see Figure 7). Quotation of touch options is done as a percentage of the possible payout amount, which can be seen as the (discounted) probability of the payout happening. Looking at the quotation as the probability of hitting the barrier, we will see for the one-touch option the effect of the varying volatility and black swans, explained in the previous article. Since we have many small moves compared to a normal distribution, options close to the barrier will be more expensive than if the moves where normally distributed. Likewise if there are more extreme moves, one-touch options with more extreme touch levels will be more expensive due to the increased likelihood of touching. Finally, one-touch options in-between the two extremes will actually trade at a lower price than if the price moves of the underlying were normally distributed. In this article we have touched upon the subject of exotic options, there exist many other forms of exotic options such as chooser options, basket options, lookback options, to mention a few of their colorful names. These will be left alone for now. The options explained in this article cover the most heavily traded exotic options which we consider an interesting starting point for most traders. Exotic Options: A Getaway From Ordinary Trading Exotic options are like regular options, except that they have unique features that make them complex. These unique features adapt themselves to situations that might otherwise require some rather crafty financial engineering. Situations requiring an all-or-nothing-style hedge. situations where an investor faces exchange-rate and price risk, as well as many other situations, can be solved with these tidy packages. Here well go over a few different kinds of exotic options and how they might be used in your portfolio. Binary Options A binary, 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 assets 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. If youre having trouble imagining this scenario, lets look at an example. Suppose you purchase a binary call option at a premium of 5.50, with a stated payout of 10 on XYZ at the strike price of 50. Lets fast forward: its now the expiry date, and XYZ is at 50.25. Because the underlying asset, XYZ, is above the strike price of 50, you receive a lump sum payout of 10. Conversely, if XYZ is at 49, you will not receive anything. If XYZ is priced at 120 on the expiration date, your payout is still 10. In this example, the fictional XYZ ticker has an equity as the underlying asset. You will find, however, that 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, youll find early exercise impossible because the underlying conditions will not have been met. Bermuda Options Whats roughly halfway between the United States and Europe Its a tiny place called Bermuda. If youre familiar with options, youll know theres a difference between what are called American options and European options. American options can be exercised anytime between their purchase and the expiry date. European options, on the other hand, can only be exercised at the expiry date. It makes sense then that Bermuda options will lie somewhere in between. Bermuda options can be exercised at the expiry date as well as certain specified dates in between the creation and expiration of the options 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 Quantity-adjusting options, also called quanto options for short, expose the buyer to foreign assets but provide the safety of a fixed exchange rate in the buyers 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 Brazils 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 an additional premium if they are willing to take on this additional risk of currency exchange as well. Benefits Vs. Drawbacks When it comes to pricing options, traditional options can be priced using the Black-Scholes option pricing formula. Exotic options cant be priced as easily, at least not with a measure as widely accepted as the Black-Scholes. This can serve as a benefit as well as a drawback, as the inherent mispricing of exotic options may either work for or against the investor. Another dilemma is the availability and risk of liquidity one takes on with exotic options. While some exotic options have fairly active markets (the binary option) others are mostly thinly-traded over-the-counter instruments. Some might even be pure dual-party transactions, with no liquidity, as names are stated in the underlying contract. The Bottom Line 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 opportunity to sophisticated quantitative investors. There are many varieties of exotic options, too numerous to describe here, but if you know how to use them, you can learn to profit from nearly any trading scenario.
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