Exotic options are--as their name implies--more complicated than commonly traded vanilla options. For example, exotic options may have multiple triggers that determine the option’s profitability or have more than one underlying securities. These options are generally traded over-the-counter rather than on traditional options exchanges like the Chicago Board of Trade (“CBOT”).
In this article, we’ll take a look at five examples of exotic options and how they differ from traditional vanilla stock options.
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Compound, or split-fee, options are simply options on options. That is, buyers are purchasing the right to acquire another option at a certain price and time rather than equity or other underlying assets. These options can include call on call (“CoC”) (“Cacall”), call on put (“CoP”) (“Caput”), put on put (“PoP”), or put on call (“PoC”) arrangements, providing traders with greater leverage than traditional options.
These options are typically used in the foreign exchange and fixed income markets, since there are uncertainties about the option’s risk protection. For example, caput options are useful in the mortgage market to offset the risk of interest rate fluctuations between the time a mortgage commitment is made and the date that the mortgages are scheduled to be delivered to the trader.
Barrier options change in value in leaps as soon as the stock price reaches preset price or time barriers. For example, an option might pay out a 5% premium to the strike price if it’s exercised after one month. These options can include up-and-out, down-and-out, up-and-in, and down-and-in varieties depending on where the spot price starts and where it has to move in order to be knocked in or out.
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Barrier options are primarily used in the foreign exchange and equity markets in order to purchase options for a smaller premium. For example, if a trader believes that an equity will rise in price – but not beyond a certain level – they can purchase a barrier option at that level and pay less premium than a traditional option. They can also be used in the opposite situation when using put options.
Lookback options have payoffs that depend on the maximum or minimum underlying asset’s price over the life of the option. That is, the option enables holders to “look back” over time to determine the payoff amount. The two types of lookback options are floating strike – where the strike price is determined at maturity – and fixed strike – where the strike price is fixed.
Lookback options are most commonly used on major U.S. index equities and futures, providing investors with a way to avoid timing issues. Since they remove that risk, these options command a much higher premium than traditional options. Lookback options are also only settled in cash, since they involve looking into the past to determine the trade’s current profitability and timing.
Chooser options give the purchaser a fixed period of time to decide whether the option will be a European call or put option. For stocks without a dividend, the same strategy can be obtained using one call option and one put option with the same strike price in what’s commonly referred to as a straddle strategy. The difference is that chooser options don’t require the holder to pay for both options entirely.
Chooser options are most commonly used when the trader expects large price fluctuations ahead, such as during FDA decisions or patent litigations, although the majority of the exotic options are issued on larger equity indexes. As opposed to a straddle, traders can often establish chooser options at a lower upfront cost, although the profitability dynamics of the trade may vary.
Rainbow options differ from traditional options in that they are linked to two or more underlying assets. In order for the option to become profitable, all of the underlying assets must move in the predicted direction. For example, a rainbow option might allow the buyer to exchange 10 shares of MSFT for one share of IBM, which means they’d make money if MSFT shares rose relative to IBM shares.
Rainbow options are most commonly used when valuing natural resources, since they depend on both the price of the natural resource and how much of the resource is available in a deposit. Traders use rainbow options to bet on both the price and quantity of a natural resource deposit before the option will take effect. Of course, the use of two variables makes these options riskier than traditional options.
The Bottom Line
Exotic options provide a great way for traders to take advantage of different trading dynamics that traditional options can’t address. However, the trade-off is that these options almost always trade over-the-counter, are less liquid than traditional options, and are significantly more complicated to value. Traders should keep these issues in mind before using these options in live trading.
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