10 Types of Exotic Options

Introduction

 

Standard European and American options or the options that are traded on the stock exchanges are termed plain vanilla options. Plain vanilla options are traded quite extensively by hedgers, speculators and arbitrageurs for their respective purposes.

 

Apart from the plain vanilla options, there exists other types of options that are introduced to cater to the varying needs of option traders. Derivative dealers design various exotic options in order to cater the varying needs of their clients and therefore, such options are usually traded over-the-counter. 

 

Since exotic options are usually not traded on exchanges, they form a very low proportion of the total number of option contracts that are traded and are highly illiquid in nature. Essentially, the exotic or rare nature of such options presents an option seller with an unparalleled opportunity presented by a distinctive need of an option buyer. There are however several uncommon types of risks involved while dealing in such types of options. 

 

This blog aims to explore the various commonly used exotic or non-standard options based on a single underlying asset. 

 

(Also read: What are Derivatives & How are They Used?)

 

 

Types of Exotic Options

 

1. Non-Standard American Options:

 

Unlike European options which only allow the exercising of an option at the expiry date, American options can be exercised at any time before the option’s expiration date. These options are varied and traded on the over-the-counter markets in the following ways:

 

• Restricting the exercise to certain dates: Such options are called Bermudan options. Interest rate options may be Bermudan in nature, providing the option buyer an opportunity to exercise only on the interest payment dates. 

• Adding an initial lock-out period: There may be an initial lock-out period or a period in which the option can not be exercised. Employee stock options may have an initial lock-out period.

• Changing the strike price during the life of the option: There may be an option allowing the issuer to change the strike price as time passes. 

 

 

2. Forward Start Options: 

 

A forward start option is one that starts at a future date. Typically, it is indicated that the option will be at-the-money when it begins. If a company guarantees that employee stock options will be awarded at a later period, they might use forward start options.

 

(Related blog: A Guide to Option Trading Strategies for Beginners)

 

 

3. Gap Options: 

 

A gap option is a European call or put option where the price triggering a payoff is different from the price used in calculating the payoff. Suppose the trigger price is K₂ and the price used in calculating the payoff is K₁ and S_T is the strike price. This means that the payoff from a call option will be S_T - K₁ if ST is greater than or equal to K₂. Alternatively, the payoff from a put option will be K₁ - S_T if S_T is less than or equal to K₂.

 

Range for ST	Payoff from Gap Call Option	Payoff from Gap Put Option
ST <= K2	0	K1 - ST
ST > K2	ST - K1	0

 

 

4. Cliquet Options: 

 

A cliquet option is a set of forward start options with certain rules for determining the strike prices. A cliquet option, for example, may provide five call options: a one-year option, a one-year option that starts in one year, a one-year option that starts in two years, a one-year option that starts in three years, and a one-year option that starts in four years. 

 

As a result, this portfolio includes a standard one-year option as well as four forward start choices. The strike prices may initially be at-the-money for all the options in order to determine the strike price of the options. There may be more complex rules depending on the nature of the requirement.

 

 

5. Chooser Options: 

 

With a chooser option, the holder has a period of time (after purchasing the option) where he or she can choose whether it is a put option or a call option. For example, the holder of a two-year European option might be allowed to choose whether it is a call option or a put option at the end of the first year. 

 

One feature of chooser options is that they can be viewed as packages of call options and put options with different strike prices and times to maturity. (Source)

 

 

6. Binary Options: 

 

As suggested by the name, binary options are options that pay a fixed amount or the asset at maturity if the underlying asset moves in the favour of an option buyer and zero, otherwise. Binary options can be classified into the following 4 categories:

 

• Cash-or-nothing call: This pays a fixed amount if the asset price is above the strike price at maturity and zero otherwise.

• Cash-or-nothing put: This pays a fixed amount if the asset price is below the strike price at maturity and zero otherwise.

• Asset-or-nothing call: This pays an amount equal to the asset price if it is above the strike price at maturity and zero otherwise.

• Asset-or-nothing put: This pays an amount equal to the asset price if it is below the strike price at maturity and zero otherwise.

 

(Must read: A Black-Scholes Options Pricing Model (BSOPM))

 

 

7. Asian Options: 

 

Asian options provide a payoff dependent on an arithmetic average of the underlying asset price during the life of the option. The average price is usually calculated using periodic observa-tions (e.g., at the end of each day). Suppose K is the strike price, S_T is the final asset price, and S_average is the average asset price. 

 

There are four types of Asian options: 

 

• Average price calls: These provide a payoff at maturity equal to max(S_average - K, 0).

• Average price puts: These provide a payoff at maturity equal to max(K - S_average, 0).

• Average strike calls: These provide a payoff at maturity equal to max(S_T - S_average, 0).

• Average strike puts: These provide a payoff at maturity equal to max(S_average - S_T, 0).

 

 

8. Lookback Options: 

 

The payoff from a lookback option depends on the maximum or minimum asset price reached during the life of the option. 

 

There are four types of lookback options:

 

• Floating lookback call: A floating lookback call gives a payoff equal to the amount by which the final asset price exceeds the minimum asset price.

• Floating lookback put: A floating lookback put gives a payoff equal to the amount by which the maximum asset price exceeds the final asset price.

• Fixed lookback call: A fixed lookback call gives a payoff equal to max(S_max - K, 0), where S_max is the maximum asset price in a given time frame and K is the strike price.

• Fixed lookback put: A fixed lookback put gives a payoff equal to max(K - S_min , 0), where S_min is the minimum asset price in a given time frame and K is the strike price.

 

(Recommended blog: Commodity Trading: An Overview)

 

 

9. Barrier Options: 

 

Barrier options have payoffs that depend on whether the asset price reaches a particular barrier. There are four types of barrier options.

 

• Down-and-out: This is a European (call or put) option that ceases to exist if the asset price moves down from its initial level to the barrier level during the life of the option.

• Down-and-in: This is a European (call or put) option that comes into existence if the asset price moves down from its initial level to the barrier level during the life of the option.

• Up-and-out: This is a European (call or put) option that ceases to exist if the asset price moves up from its initial level to the barrier level during the life of the option.

• Up-and-in: This is a European (call or put) option that comes into existence if the asset price moves up from its initial level to the barrier level during the life of the option. 

 

Options that cease to exist when a barrier is reached are some-times referred to as knock-out options, whereas options that come into existence when a barrier is reached are referred to as knock-in options.

 

Parisian options are similar to standard barrier options, but they have one important difference: The asset price must remain above or below the barrier for a specified number of days before the option is knocked in or out.

 

10.  Compound Options: 

 

A compound option is an option on another option. Thus, there are two strike prices and two maturity dates. Suppose the maturity dates are T₁ and T₂ such that T₂ > T₁ and the strike prices corresponding to those maturity dates are K₁ and K₂ respectively. 

 

Four types of compound options are as follows;

 

• Call option on call option: The holder has the right to pay K₁ at time T₁ in order to obtain a long position in a call option on an asset. This call option allows the asset to be bought for K₂ at time T₂.

• Put option on call option: The holder has the right to receive K₁ at time T₁ and obtain a short position in a call option on an asset. This call option allows the asset to be bought for K₂ at time T₂.

• Call option on put option: The holder has the right to pay K₁ at time T₁ in order to obtain a long position in a put option on an asset. This put option allows the asset to be sold for K₂ at time T₂.

• Put option on put option: The holder has the right to receive K₁ at time T₁ and obtain a short position in a put option on an asset. This put option allows the asset to be sold for K₂ at time T₂.

 

(Must read: 6 Basic Trading Principles)

 

The Bottom Line

 

Option traders have creatively developed exotic options over the years. This blog discussed some of the most widely used exotic options. It is important to note that this blog only covered the exotic options’ whose payoffs are dependent on the price of a single underlying asset.

 

(Must catch: 5 Option Greeks: Delta, Gamma, Theta, Vega & Rho)

 

Under the category of exotics involving single assets, there are other exotics including the shout options, Madonna options, Himalaya options, and pyramid options available as well. Then there are exotics that are dependent on the price movement of multiple assets including the asset-exchange options and baset options, there are exotics that are dependent on volatility, in particular the volatility swaps. There are a lot of other types of exotic as well.

 

(Top reading: 10 Largest Stock Exchanges in the World)

 

Overall, the marketplace for exotics is in itself an exotic one and there is not a lot of retail participation here, as may be seen in the stock markets with the vanilla options being heavily traded. On the other hand, institutions and high network individuals may trade in exotic options in order to cater to their individualistic needs.