A Bermuda option is an exotic option with the defining characteristic of being exercisable on dates that lie somewhere between American and European options expiration dates.
Bermuda option puts and calls can only be exercised at predetermined times negotiated prior to initiation with the counterparty to the options contract.
The exercise terms are less flexible than American options (exercisable at any time prior to expiration) and more flexible than European options (only exercisable on the expiration date).
What Are Bermuda Options?
Bermuda options are exotic options that trade in the over-the-counter (OTC) market. The key difference between more common American and European options is that Bermuda options can only be exercised by the holder at predetermined dates. These exercise restrictions result in Bermuda options being cheaper than American options, but more expensive than European options.
💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options trading account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.
How Do Bermuda Options Work?
Bermuda options work similarly to how standard American and European options function. Recall that when trading options there is a buyer and seller.
The call option buyer, also called the holder, has the right but not the obligation to purchase an underlying asset at a pre-specified time and price. The put buyer similarly has the right to sell.
American options can be exercised at any time, whereas European options can only be exercised at expiration. However, with Bermuda options the holder negotiates the exercise dates for the option and these dates are outlined in the contract.
Recommended: Exercising Options? What Does It Mean & When to Exercise
It is common for a Bermuda option to have an exercise date just once per month and at the option’s expiration date. Bermuda options are considered a restricted form of an American option, but you can think of them as a middle ground between American and European options — hence the term “Bermuda”, a not so subtle reference to the island lying between the two regions.
If a Bermuda call option holder wishes to exercise early, they can use specific dates to do so. Bermuda options are typically cash-settled, which means that it is uncommon to exchange the underlying assets. Rather cash is exchanged based on the difference between the current market price of the underlying asset and its strike price.
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Pros and Cons of Bermuda Options
Bermuda options are considered “exotic” options which means they are typically reserved for the sophisticated and experienced options trader. As such, traders should become familiar with the many pros and cons of Bermuda options. You might find that you are more comfortable sticking to the more common American and European options.
Pros of Bermuda Options
Bermuda options are usually less expensive to buy compared to American options due to the exercise restriction placed on the buyer. American options exercisable at any time through expiration trade at a higher premium due to this flexibility.
For sellers, Bermuda options can bring in more premium than writing European options since European exchange-traded options can only be exercised on the expiration date.
If you are looking for customized approaches to your options trading strategies, then Bermuda options could be a good choice in contrast to the more common two categories that are standardized.
Multinational companies might seek Bermuda options to hedge their foreign currency exposure. A U.S. firm that receives payment in another country must convert funds to dollars. That corporation can reduce its option premium cost by using Bermuda options instead of American options and align the options exercise dates with the relevant transactions they are hedging.
Cons of Bermuda Options
In contrast to American and some European options, Bermuda options trade through the OTC market in bilateral deals. The OTC market often features wider bid/ask spreads compared to trading through options exchanges.
Of course, only being able to exercise once per month may not be ideal for the active trader.
Moreover, Bermuda options are pricier than European options, so if you plan to hold through expiration, then owning European options can save on premium costs.
| Pros | Cons |
|---|---|
| Less restrictive compared to European options | More restrictive compared to American options |
| Cheaper than American options | More expensive than European options |
| Helpful for large multinational firms that face foreign currency exposure and risk | Trade through the less liquid OTC market |
Bermuda Options vs American Options
Bermuda options are different from American options due to their more restrictive exercise periods. The option to exercise at any time through expiration is a key benefit for a holder, so American options are generally more expensive than Bermuda options.
American options are likely the most well-known category of options and many trade through exchanges like the Chicago Board Options Exchange (CBOE) instead of the OTC market resulting in better price discovery and liquidity.
American options can be priced using the Black Scholes option pricing model, but Bermuda options cannot be priced that way.
Also, most brokers do not allow you to buy options using margin, or borrowed funds. You should check with your broker and weigh the pros and cons to determine if it’s a good idea to margin trade.
Bermuda Options vs European Options
The key difference between Bermuda options and European options is that the former can be exercised during specific times in the life of the option. European options are only able to be exercised on the day of expiration. The added flexibility of Bermuda options makes them more expensive.
| American Options | Bermuda Options | European Options |
|---|---|---|
| Most expensive due to the high degree of flexibility when exercising | Less expensive than American options but more expensive than European options | Least expensive since they can only be exercised at expiration |
| Often used by retail traders with stocks and exchange-traded funds (ETFs) | Commonly used by institutions seeking to hedge currency or foreign interest rate risk | Many index options are settled as European style |
| Traded on exchanges and are standardized | Traded through bilateral OTC markets and can be customized | Traded mainly through OTC markets with some index option listed on exchanges |
Bermuda Options Example
It helps to walk through a Bermuda option example to better grasp how it functions.
A trader wishes to buy a Bermuda call option that expires in three months from now on shares of XYZ stock that currently trades at $100 per share. The strike price is $110 and the premium is $5. The contract terms state that exercising can only take place on the first business day of each month.
The following month, the stock price jumps to $120 and the option price is $12 with a bid/ask spread on the OTC market of $10/$14. The trader chooses to exercise early rather than receive the bid price.
It’s important to recognize that as with other options, exercising early is not always the most profitable choice when trading options.
The Takeaway
Bermuda options can provide a cheaper alternative to American options with the trade-off of restrictive exercise terms. However, be aware of all of the pros and cons before pursuing this exotic options strategy.
Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
FAQ
Why are Bermuda options called that?
Bermuda options got the name because its characteristics lie between those of American and European options — much the way the island of Bermuda lies between America and Europe. Bermuda options can only be exercised on specific dates. American options can be exercised at any time while European options can only be exercised at expiration.
How are Bermuda options priced?
Bermuda options are priced similarly to other options, but the premiums tend to be lower than American options since the holder can exercise them only at predetermined periods. The cost of a Bermuda option is typically more expensive than European options. Complex option pricing models are necessary since the Black Scholes option pricing model cannot be used on Bermuda options.
How rare are Bermuda options?
Bermuda options are rare compared to common styles like European and American options. A Bermuda option is considered an exotic option category that usually features an optionable date in one-month increments. Bermuda options are so rare that they are traded bilaterally in the OTC market, not through an options exchange.
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