Types of exotic options
Exotic options are
financial derivatives with more complex features compared to standard
"vanilla" options like European or American calls and puts. These
unique features give exotic options a more specialized risk-reward profile,
making them useful in various market scenarios. They are often customized to
meet the needs of institutional investors, hedge funds, or corporations seeking
specific hedging strategies. Below, we’ll explore different types of exotic
options and their distinctive characteristics.
1. Barrier options
Barrier options are
a class of options where the payoff depends not just on whether the underlying
asset reaches a specific level but also on whether it hits or avoids certain
price barriers.
Knock-in options:
This type of barrier option becomes
active only if the underlying asset hits a predetermined barrier price. There
are two types of knock-in options:
Up-and-in: This option is activated if the asset price
rises above the barrier.
Down-and-in: This option becomes active if the asset price
falls below the barrier.
Knock-out options: In
contrast, knock-out options expire worthless if the asset hits a certain price
level. Types include:
Up-and-out: The option becomes worthless if the asset
price goes above a specific barrier.
Down-and-out: If the asset price falls below a certain
level, the option is deactivated.
Use case: Barrier options are often used by investors
who have a directional view of the market and want a cheaper way to gain
exposure to an asset, as they usually have lower premiums compared to vanilla
options.
2. Asian options
Asian options (also
known as average price options) derive their value from the average price of
the underlying asset over a specified period, rather than the price at a
specific point in time.
Average price call:
The option pays the difference between
the average price of the asset and the strike price if it is positive.
Average price put:
The option pays the difference between
the strike price and the average price if the difference is positive.
Use case: Asian options reduce the impact of market
volatility on the final payoff, making them ideal for investors looking to
hedge against sharp price movements over time.
3. Digital (Binary) options
A digital option,
also called a binary option, pays a fixed amount if the underlying asset
reaches a specified price or condition, and pays nothing if it does not. The
payoff is either a set amount or zero.
Cash-or-nothing: The investor receives a fixed amount of cash
if the option finishes in the money (i.e., the underlying price is higher than
the strike for a call or lower for a put), and nothing otherwise.
Asset-or-nothing:
The payoff is either the value of the
underlying asset or zero.
Use case: Digital options are often used by speculators
who want to bet on a specific price outcome with limited downside risk.
4. Chooser options
Chooser options
give the holder the flexibility to decide, at a future point, whether the
option will be a call or a put. This choice is made after a specific date but
before the option expires.
Use case: This option is suitable for investors
uncertain about future market directions. By delaying the decision, they can
react to market developments and lock in the best outcome.
5. Lookback options
Lookback options
allow the holder to “look back” over the life of the option and choose the most
favorable price of the underlying asset for determining the payoff.
Lookback call: The holder can select the lowest underlying
price over the option’s life to maximize the difference between the strike and
this minimum price.
Lookback put: The holder selects the highest underlying
price over the option’s life to maximize the difference between this maximum
price and the strike.
Use case: These options are beneficial for reducing
regret. They are typically more expensive than standard options because they
eliminate the need to time the market.
6. Shout options
Shout options allow
the holder to “shout” or lock in a profit at a chosen point during the option’s
life while still maintaining the potential for further gains if the market
moves favorably.
Example: If the holder has a shout call and the
underlying asset rises, they can shout to lock in the gain at that point.
However, if the asset continues to rise, they also benefit from the higher
price at expiry.
Use case: Shout options are useful for investors who
want to secure gains while still leaving room for additional upside potential.
7. Compound options
Compound options are
options on other options, meaning they give the holder the right to buy or sell
another option. There are four types of compound options:
Call on a call: The right to buy a call option.
Call on a put: The right to buy a put option.
Put on a call: The right to sell a call option.
Put on a put: The right to sell a put option.
Use case: These options are used in highly volatile
markets, especially when the investor wants to hedge the cost of purchasing an
option at a later date.
8. Basket options
Basket options are
based on a portfolio (or basket) of underlying assets rather than a single
asset. The payoff depends on the performance of the basket of assets.
Example: A basket call option on a portfolio of stocks
would pay out based on the weighted average price of the stocks in the basket.
Use case: Basket options are commonly used by investors
who want to hedge or speculate on the overall performance of a group of assets,
such as an index or a sector.
9. Rainbow options
Rainbow options are
options on multiple assets, where the payoff is determined by the performance
of more than one underlying asset. These options provide exposure to two or
more assets, which can be different types like stocks, commodities, or
currencies.
Example: The option could pay based on the
best-performing asset in a group (best-of option) or the worst-performing asset
(worst-of option).
Use case: Investors use rainbow options when they want
to hedge exposure to multiple assets or speculate on the relative performance
of different asset classes.
10. Time (Calendar) options
Time options give
the holder flexibility in choosing when to exercise the option within a certain
timeframe. They can be a variation of standard options but with a specific
time-based feature, such as allowing the holder to exercise at any point before
expiry (like American options) or at specific dates.
Use case: These options are useful when an investor
wants to have flexibility around key market-moving events or announcements
without committing to a single expiry date.
11. Quantos
A Quanto (Quantity
Adjusted Option) is a type of derivative where the underlying asset is
denominated in one currency, but the payoff is in another currency, with a
fixed exchange rate.
Example: An investor can buy a Quanto on a foreign
stock index with the payoff in their domestic currency, avoiding exposure to
currency risk.
Use case: Quantos are beneficial when investors want to
speculate on foreign assets but avoid the volatility of exchange rates.
Conclusion
Exotic options
offer a wide range of opportunities for investors seeking tailored exposure,
hedging strategies, or speculative opportunities. They cater to more
sophisticated market participants who are comfortable with their complex payoff
structures. However, with greater flexibility comes added risk, and exotic
options are generally more costly and less liquid than standard options.
Understanding their mechanics and use cases is critical for leveraging them
effectively in investment strategies.
