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Exotic Options
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
One-touch 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 option
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.
Double one-touch
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.
Double no-touch
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
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
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.
Balloon options
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
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.
Basket option
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).
Digital 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."
Embedded 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.
Lock-out option
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
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.
Double-trigger option
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
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 one
must notice to beware as Exotics can be complex, expensive and hard to
understand (i.e. involve high gearing).
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