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 investors because they allow the investor to bet 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 pricing tends to be higher than that of traditional options.
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 typically charge a higher price than traditional options. University of California Berkeley professor Mark Rubenstein coined the term “Exotic Options” in a 1990 paper about contracts.
The asset that underlies these options also includes non-traditional assets and securities. Exotic options can be either covered or naked call, meaning that the seller has not set aside shares or cash to meet the obligation when it expires.
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 calculate the payoff.
Investors typically buy and sell options 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 can include commodities like oil, corn and natural gas, in addition to stocks, bonds, and foreign currencies.
There are even exotic derivatives that allow traders to bet on things like the weather. Both institutional and sophisticated retail investors use customized exotic options to match their own unique risk-management needs.
💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
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 reflects on the security’s average price over one or several agreed-upon periods of time. This makes it different from a U.S. option, whose return reflects the price of the underlying asset when the holder chooses to exercise it, and different from a European option, whose payoff reflects the price of the security at the time of the option’s expiration.
2. Barrier Options
These options remain effectively dormant until activated, usually by the price of the underlying asset reaching 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 payout on a basket option reflects 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 a handful of set dates before then. This makes them different from U.S. 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 guarantee a payout to the holder if a predetermined event occurs. This all-or-nothing investment typically delivers 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 pays off depends on whether or not another option pays off. 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 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 come with a specified exercise price. Instead, an owner of a lookback option can choose the most favorable strike price from the prices at which the underlying asset has traded at throughout the duration of the option contract.
10. Spread Options
Unlike a traditional option, where the payoff depends on 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 pays an investor based on the price difference between multiple assets. The butterfly spread, which involves four separate options, is one example of a spread option.
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 have lower premiums than more flexible American options contracts.
• Investors can select and customize exotic options to fit very complex and precise strategies.
• With exotic options, investors can fine-tune the risk exposure of their portfolio.
• Investors can use exotic options to find 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 sometimes react to market moves in unexpected ways.
• The complex rules mean that exotic options have a higher risk of ultimately becoming worthless.
💡 Quick Tip: Look for 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 make bets on the price of an asset without owning that asset itself. Unlike traditional options, exotic options include customizable features that investors can use to pursue a specific options trading strategy.
As many investors 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 a good idea to speak with a financial professional before diving into options trading.
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