While not as well-known as traditional options, exotic options offer unique features that can suit specific trading needs. Understanding exotic options can provide valuable tools for managing risk and maximising returns if you want to diversify your portfolio.
An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset (such as a stock) at a predetermined price within a specified period. Traditional options, often referred to as vanilla options, have straightforward terms and conditions.
On the other hand, an exotic option is a type of financial derivative that incorporates more complex features than traditional (vanilla) options. These options are highly customised to cater to specific investor needs and often include unique payoff and exercise mechanism conditions. For instance, some exotic options may only become active if the underlying asset's price reaches a certain level (barrier options) or involve multiple underlying assets (basket options).
Feature |
Traditional (Vanilla) options |
Exotic options |
Complexity |
Simple, straightforward |
Complex, with unique conditions |
Types |
Calls and puts |
Various types, including barrier, Asian, etc. |
Trading venue |
Exchange-traded |
Over-the-counter (OTC) |
Customisation |
Standardised |
Highly customised to investor needs |
Exercise mechanism |
Standard exercise rules (American/European) |
Custom exercise rules |
Payoff conditions |
Based on underlying asset price at expiration |
Can depend on multiple conditions and assets |
Risk level |
Lower complexity, easier to understand |
Higher complexity, requires in-depth knowledge |
Investor suitability |
Suitable for all levels |
More suitable for experienced investors |
Regulation |
Heavily regulated |
Less standardised, can vary by provider |
Flexibility |
Limited flexibility |
High flexibility and adaptability |
Typical users |
Retail and institutional investors |
Mainly institutional investors and experienced traders |
Pricing |
Relatively straightforward |
Complex, often requiring advanced models |
Chooser options allow the holder to choose, at a specified point in the future, whether the option will be a call or a put. This flexibility makes chooser options appealing for investors uncertain about market direction.
Compound options are options on options. In other words, an underlying asset in a compound option is another option. They give the holder the right to buy or sell another option at a future date. This option can be useful for complex trading strategies and risk management.
Barrier options have payoffs that depend on whether the underlying asset's price reaches a certain level during a specified period. They can be either knock-in (activated when a price level is reached) or knock-out (deactivated when a price level is reached). This feature makes barrier options highly customizable.
Binary options offer a fixed payout if a certain condition is met. For example, the holder receives a predetermined amount if the underlying asset's price is above a certain level at expiration. Otherwise, they get nothing.
Bermuda options can be exercised on specific dates before expiration, unlike American options (exercisable anytime) and European options (exercisable only at expiration). This feature provides a balance of flexibility and structure.
Quantity-adjusting options, or quanto options, help manage currency risk in international investments. If you invest in a foreign stock but want returns in Indian Rupees (INR), exchange rate changes can affect your profit. Quanto options fix this by basing your returns on the foreign stock's performance but paying you in INR. This way, you don't worry about currency fluctuations affecting your investment.
Look-back options let you choose the best price of the underlying asset during the option's life for your payout. This means you can "look back" and pick the highest (or lowest) price, making them useful in markets with lots of price swings.
Example: Imagine you buy a look-back option for tech stock. Over the next few months, the stock's price fluctuates a lot. With a regular option, your payout would depend on the stock's price at the end. However, with the look-back option, you can choose the highest price the stock reached during those months for her payout. This way, even if the stock price drops at expiration, you benefit from the highest price it hits. This helps you make your investment safer in a volatile market.
Asian options base their payoff on the average price of the underlying asset over a specified period. This averaging reduces the impact of volatility, making it suitable for investors looking for stability.
Basket options include several different assets, like stocks from various companies. The payout depends on how all these assets perform together. This helps spread risk, so if one stock doesn't do well, others might balance it out.
Example: You buy a basket option with stocks from three tech companies. Instead of relying on just one company's stock, your payout will depend on the combined performance of all three. This way, if one company's stock drops, the other two might still help you earn a profit, making your investment less risky.
Extendible options allow the holder to extend the option's expiration date. This flexibility can be valuable if market conditions are unfavourable at the original expiration.
Spread options involve betting on the price difference between two or more assets rather than their individual prices. This means you make a profit based on how the prices of these assets move in relation to each other. It's a way to hedge against market movements by focusing on the spread (the difference) between prices rather than the absolute prices of each asset.
Example: You as a new investor buy a spread option based on the price difference between gold and silver. You aren't concerned with the exact price of gold or silver. Instead, you profit if the price of gold increases more than the price of silver.
Shout options let you lock in a profit at any time before the option expires while keeping the option open to make more money if prices improve. This way, you secure gains while still having the chance for more.
Example: You buy a shout option on a tech stock. One day, the stock price goes up, and you use 'shout' to lock in your profit at that price. Even though you locked in this profit, you keep the option open. If the stock price increases even more before the option expires, you can make extra profit from what you already locked in.
Range options pay out if the asset's price stays within a set range during a specific time period. They're good for investors who predict prices to remain the same.
Example: You buy a range option on a stock. You believe that the stock will trade between ₹500 and ₹600 for the next three months. If the stock stays within this range, you get a payout. If the stock goes outside this range, you don't. This way, you profit from the stability of the stock price.
Exotic options offer tailored solutions to complex trading needs, providing greater flexibility and specificity than traditional options. They can help manage risk, optimise returns, and cater to unique market views. For instance, a barrier option can be structured to provide a payoff only if a stock remains within a certain range, which might suit a risk-averse investor.
A few large Indian companies are returning to exotic currency options to handle the rupee's volatility and manage foreign exchange (FX) costs and risks. These companies are using barrier options, a type of knock-out or knock-in options, which are exercisable or expire worthless based on the underlying asset's level. The Reserve Bank of India lifted a ban on these options in January 2022, allowing companies with a minimum net worth to access these products.
Exotic options provide diverse and flexible trading opportunities catering to specific investment strategies. Whether managing currency risk with quanto options or securing profits with shout options, these instruments offer unique benefits. However, it's important to understand their complexity and potential risks. For more detailed insights and expert advice, visit the Sharekhan Knowledge Centre.
Delve into the world of futures and options trading with Sharekhan expert guidance. Our comprehensive resources and intuitive platform empower you to make informed decisions and capitalize on market movements.
Embark on your stock trading journey with Sharekhan's comprehensive platform. Learn the fundamentals of equity trading, gain insights into market trends, and access powerful tools to make informed investment decisions.
Safeguard your investments with Sharekhan's secure and reliable Demat account. Our platform offers robust security features to protect your holdings, ensuring your investments are in safe hands. Open Demat account today and enjoy peace of mind while you invest.
Make informed mutual fund investment decisions with Sharekhan's expert guidance. Explore a wide array of funds to match your financial goals and risk tolerance. Start building your wealth today.
Leverage Sharekhan's market knowledge and experience to make informed decisions in the initial public offering (IPO) space. Our research and analysis equip you with the insights you need to identify promising IPOs and participate in their growth potential.