WHAT ARE DIFFERENT TYPES OF EXOTIC OPTIONS?

 

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.