This article will provide you a brief overview of exotic options. Exotic options are either variations on the profiles of payoff of the plain vanilla options or wholly different kinds of products with optionality embedded in them. It is necessary to notice that the exotic options market is most developed in the foreign exchange market. Here we will have an idea as to what is exotic option, how is it different from plain vanilla options and also the types of exotic option.
An exotic option is a kind of derivative which has features making it more complex than commonly traded products which are known as vanilla options. These products are usually traded over-the-counter (OTC), or are embedded in structured notes. Before learning about exotic options, we should have a good understanding of regular options. Both type of options the right to buy or sell an asset in the future, however the way investors realize profits using these options differs dramatically.
Difference between Exotic Option & Regular option
An exotic option is a type of option other than the standard calls and puts found on major exchanges. An investor who buys a call option has actually bought a standardized right to purchase a specific amount of an underlying asset at the agreed upon strike price, while a put option gives the investor the right to sell the specific asset at the strike when the price of the underlying decreases. These regular options are also known as plain vanilla options. Exotic options can be quite different, as the below examples show :
Chooser option: It gives the investor the right to choose whether the option is a put or a call at a certain point during the option's life. Unlike regular options that are purchased as a call or a put at initiation, these exotic options can change during the life of the option.
Barrier option: An option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price is known a barrier option. The right to purchase the underlying at an agreed strike price only realizes when the price hits the agreed upon 'barrier'. This is unlike a regular option because the holder of a vanilla (regular) option can buy the underlying at the strike price at any time after inception.
Asian option: Anyone who invests in regular options will prove to their volatility. An Asian option provides a good way to reduce this volatility. These exotic options have a payoff which depends on the average price of the underlying asset over a certain period of time as opposed to at maturity.
Note: However the types of exotic option are explained below.
The final difference between exotic options and regular options has to do with how they trade. Regular options consist of calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange. Exotic options are mainly traded over the counter, which means they are not listed on a formal exchange, and the terms of the options are generally negotiated by brokers/dealers and are not normally standardized as they are with regular options.
Features of exotic Option
An exotic product could have one or more of the following features :
- The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract's life (it could be an Asian option depending on some average, a look back option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, peroni options, range options, etc.)
- It usually depends on more than one index (as in a basket options, Himalaya options, Peroni options, or other mountain range options, outperformance options, etc.)
- There could be callability and putability rights which form the types of basic option.
- It involves foreign exchange rates in various ways, such as a quanto or composite option.
Types of Exotic Options :
- One-touch options
- No-touch option
- Double one-touch
- Double no-touch
- Digital options
- Asian options
- Balloon options
- Basket option
- Digital Option
- Barrier options
- Embedded Option
- Lock-out option
- Look-back option
- Single-barrier options
- Double-trigger option
- Weather options
A one-touch option is one of the most popular exotics that are profitable if the price of the currency pair touches a specified price within a certain period of time. Timing is especially significant with exotic options. Each broker may have different cut-off conventions but exotic options are timed against the New York cut-off, which is 10 a.m. ET. However, some brokers will set the cut-off time at 24:00 GMT (4 a.m. ET), so it is necessary to confirm the time before making a trade.
One-touch options are usually used for conditions when there is a strong opinion about the direction of a currency pair and you are convinced the move will happen soon. A one-touch option with a far-away target (perhaps 200 pips away) and a very short time span (24 to 48 hours) will have a very high reward-risk ratio (typically 3:1 or less) precisely because there is seldom any payout for such trade.
No-touch options are profitable only when the price of a currency pair does not reach the target by a specified time. A no-touch option offers better payout odds when the strike price is closer to the market price but the expiration date is farther away because the chances the currency will not touch the strike price diminish considerably the longer the trader has to wait. One interesting factor of the no-touch is the fact the underlying currency pair does not have to move away from the strike price in order to produce a profit. The currency pair simply has to stay relatively stagnant for the trader to collect a payout.
In double one-touch option you can select two strike-price barriers that provides a payout if either one is touched. The double one-touch is similar to a standard long strangle or straddle option trade and it is a good tool to use when you have no strong opinion about direction of the price movements but you expect volatility to explode.
The double no-touch option is just the opposite of the double one-touch. It is appropriate for situations in which you anticipate a range-bound market where there is no clear indication about the direction and expect volatility to be low.
One-touch and no-touch options are precisely time sensitive. A one-touch will be significantly cheaper the less time there is to expiration because the odds of reaching the target is greatly reduced, while a no-touch will be priced opposite to one-touch because the chances of not touching the target will diminish the more time is left on the contract.
However, the double one-touch and double no-touch options will have the same pricing parameters in terms of time but will vary greatly with respect to the volatility. Double one-touch options, for example, will become progressively more expensive as the barriers narrow.
Digital options produce a payout only if the spot price meets or exceeds the selected barrier price at expiration. Digital options are less expensive than one-touch options with the same strike and expiration date whereas Digital premiums can be half the price of no-touch options premiums with the exact same strike price and expiration dates, but the trader has to weigh the advantage of lower cost against the risk price will settle even 1 pip below the target at expiration.
Asian options are options in which the average price over a period of time is the underlying variable. Because of this, Asian options have a lower volatility and hence are rendered at cheaper relative to their European counterparts. They are commonly traded on currencies and commodity products having low trading volumes.
They are divided into three categories; arithmetic average Asians, geometric average Asians and both these forms can be averaged on a weighted average basis, whereby a given weight is applied to each stock that is being averaged. This is used for attaining an average on a sample with a highly skewed sample population.
An option whose notional payments increase significantly only after a set threshold is broken. It is commonly used in foreign exchange markets and these options provide greater leverage to the holder. The main idea behind the balloon option is that after the threshold is exceeded, there is an increase in regular payout.
Barrier options are path-dependent options which appear in many flavours and forms, but their key characteristic is that these types of options are either initiated or exterminated upon reaching a certain barrier level; they are either knocked in or knocked out.
A basket option has all the characteristics of a standard option, except that the strike price is based on the weighted value of the component currencies which is calculated in the buyer's base currency. The buyers order the maturity of the option, the foreign currency amounts which make up the basket, and the strike price is expressed in units of the base currency.
At expiry, if the total value of the component currencies in the spot market is less favourable than that of the strike price of the basket option the buyer would let the option lapse. If it is more favourable, the buyer would exercise the option and exchange all of the component currencies for the pre-specified amount of the base currency (i.e. the strike price of the option).
An option whose payout is fixed only after the underlying stock exceeds the predetermined threshold or strike price is known as Digital option. It is also known as "binary" or "all-or-nothing option."
An option which is an inseparable part of another instrument is known as embedded option. A common embedded option is usually the call provision in most corporate bonds.
A lock-out option pays only if the value of the underlying does not go beyond a specified value whereas a double-lockout option pays if the value of the underlying asset remains confined within a specified range.
Look back option
A look back option pays depending on the highest value reached by the underlying during the contract period. Some of the look back options use the highest value reached by the underlying during the contract period to determine the amount of settlement. One formula for the lookback is:
Look back = Maximum (Spot Price at Expiration – Minimum Spot Price over Term of Contract, or 0)
Single-barrier options are options which have a single trigger price that is either above or below the strike price whereas double-barrier options have trigger prices that are above and below the strike price. Because the option may either not come into existence or pass out of existence, barrier options are generally cheaper than the standard options but the double-barrier options are the cheapest.
A double-trigger option, often used for insurance purposes, pays off when 2 events occur. A company or an insurance company will buy this option to limit losses that are unlikely, and it would be very expensive if they both occur. An example would be if a company had a large property loss in a foreign country due to changes in the foreign exchange rate made the loss much more expensive.
Weather options pay off only for unusual weather. Many businesses that are affected by the weather, such as utilities and ski resorts, use these options to keep cash flow more consistent.
Exotic options are frequently used to make the price of options (and hedging) cheaper, by excluding some opportunities for exercise but we must notice to beware as Exotics can be complex, expensive and hard to understand (i.e. involve high gearing).