What Are Exotic Options?

Introduction

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.

What Is An Exotic Option?

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).

Exotic Options vs Traditional Options

Types Of Exotic Options

1. Chooser Options

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.

2. Compound Options

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.

3. Barrier Options

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.

4. Binary Options

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.

5. Bermuda Options

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.

6. Quantity-Adjusting Options

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.

7. Look-Back Options

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.

8. Asian Options

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.

9. Basket Options

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.

10. Extendible Options

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.

11. Spread Options

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.

12. Shout Options

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.

13. Range Options

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.

Why Trade Exotic Options?

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.