Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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An option is a financial instrument that gives the buyer the right to purchase or sell an underlying security, such as a stock, during a set time period for an agreed-upon price. They are popular with some investors because they allow the investor to speculate on the price increase or decrease of a stock, without owning the stock itself.
Exotic options are a class of options that allow investors to take advantage of some features of options contracts to pursue other strategies. Exotic options are non-standard, customizable contracts that may trade over the counter (OTC) and differ in pricing from traditional options.
Key Points
• Exotic options are complex financial instruments that can be customized using non-standard payoffs, expiration dates, and underlying assets.
• These options help enable sophisticated investors to tailor risk exposure and implement unique strategies.
• Exotic option strategies may involve higher or lower costs, and can offer more or less flexibility than traditional contracts, depending on the specific structure.
• Types may include Asian, barrier, basket, Bermuda, and binary options, each with distinct characteristics.
• Investors may benefit from financial advice when considering exotic options due to their complexity and high degree of risk.
What Is an Exotic Option?
Exotic options are hybrid securities that offer unique and often customizable payment structures, expiration dates, and strike prices. For those features, they may be priced higher or lower than traditional options, depending on the structure. University of California Berkeley professor Mark Rubinstein popularized the term “Exotic Options” in a 1990 paper about contracts.
To understand what makes an exotic option exotic, let’s review a traditional, plain-vanilla options contract and how it works. With a traditional option, the owner can buy or sell the underlying security for an agreed-upon price either before or at the option’s predetermined expiration date. The holder is not, however, obligated to exercise the option, hence the name.
An exotic option typically has all of those features, but with complex variations in the times when the option can be exercised, as well as in the ways investors may calculate the payoff.
Exotic options are typically traded in the over-the-counter (OTC) market, a smaller dealer-broker network. An exotic option may have underlying assets that differ from those offered by traditional options. Those underlying assets may include commodities like oil, corn and natural gas, in addition to stocks, bonds, and foreign currencies.
There are even exotic derivatives that allow for trading on things like the weather. Both institutional and sophisticated retail investors may use customized exotic options to match their own unique risk-management needs.
11 Types of Exotic Options
There are many types of exotic options that investors can purchase for exotic options trading. Here’s a look at some of them:
1. Asian Options
One of the most common forms of exotic options contract, the Asian option is a contract whose payoff to the holder is based on the average price of the underlying asset over one or more periods, rather than solely on the price at exercise. This makes it different from an American option, whose payout depends on the price of the underlying asset when the holder chooses to exercise it, and different from a European option, whose payoff depends on the price of the security at the time of the option’s expiration.
2. Barrier Options
These options may remain effectively dormant until activated (knock-in), or may terminate if a barrier is reached (knock-out), usually when the price of the underlying asset reaches a certain level.
3. Basket Options
Unlike traditional options, which typically have a single underlying asset, basket options contracts depend on the price movements of more than one underlying asset. For holders, the value of a basket option may be tied to the weighted average of the assets underlying the contract.
4. Bermuda Options
The main differentiator of Bermuda options is when the holder can exercise them. An investor can exercise a Bermuda option at its expiration date, and at certain set dates before then. This makes them different from American options, which holders can exercise at any point during the contract, and European options, which can only be exercised at expiration.
5. Binary Options
Sometimes called digital options, binary options are unique because they only provide a payout to the holder if a predetermined event occurs. This all-or-nothing investment may provide a predetermined payout or asset if the agreed-upon event occurs.
6. Chooser Options
With ordinary options contracts, the investor must decide upfront if they’re buying a call (right to buy the underlying security) or put (right to sell the underlying security) option. But with a chooser option, the holder can decide whether they want the option to be a put or call option at a predetermined date between when they buy the chooser option and when the contract expires.
7. Compound Options
These options, often called split-fee options, allow investors to buy an option on an option. Whether or not a compound option may result in a payout depends on the value or outcome of the underlying option. Investors in compound options have to make their decisions based on the expiration dates and strike prices of both the underlying option, as well as the compound option itself.
8. Extendible Options
The main advantage that extendible options offer is that they give an investor the ability to postpone the expiration date of the contract for an agreed-upon period of time. This can mean adding the extra time for an out-of-the-money option to potentially get into the money, a feature that’s priced into the original option contract.
Extendible options can be holder-extendible, meaning the purchaser can choose to extend their options. They can also be writer-extendible, meaning that the issuer has the right to extend the expiration date of the options contracts, if they so choose.
9. Lookback Options
Lookback options differ from most options because they do not necessarily come with a specified exercise price. Instead, depending on type, the strike (floating-strike) or the payoff (fixed-strike) is automatically determined by the most favorable price the underlying asset reached during the contract.
10. Spread Options
Unlike a traditional option, where the payout may reflect the difference between the contract’s strike price and the spot price of the underlying asset when the investor exercises the contract, a spread option may provide a return tied to the price difference between multiple assets.
11. Range Options
For highly volatile assets, some investors choose to use range options, because their payout is based on the size of the difference between the highest and lowest prices at which the underlying asset trades during the life of the range options contract.
Pros and Cons of Exotic Options
There are benefits and drawbacks to using exotic options.
Pros
• Some exotic options may have lower premiums than comparable American-style options contracts.
• Investors can potentially select and customize exotic options to fit very complex and precise strategies.
• With exotic options, investors can potentially fine-tune the risk exposure of their portfolio.
• Investors can use exotic options to seek opportunities in unique market conditions.
Cons
• Many exotic options come with higher costs and less flexibility than traditional contracts.
• There are no exotic options that guarantee a profit.
• Because of their unique structures, exotic options may react to market moves in unexpected ways.
• The complex rules mean that exotic options may carry a higher risk of ultimately becoming worthless.
💡 Quick Tip: Consider an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
The Takeaway
Exotic options are complex financial instruments that allow investors to speculate on the price of an asset without owning that asset itself. Unlike traditional options, exotic options include customizable features that investors could use to pursue a specific options trading strategy.
As many investors may know, trading options — of all types — is relatively advanced and requires a good amount of background knowledge and understanding of intricate financial assets. For that reason, it may be advisable to speak with a financial professional before diving into options trading.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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