Introduction

In the world of financial derivatives, options play a crucial role in providing investors with flexibility and risk management tools. While standard American options offer well-defined features and characteristics, the realm of exotic options introduces a realm of customization and complexity. In this chapter, we delve into the intriguing process of transforming standard American options into nonstandard American options, exploring how these modifications can enhance risk-reward profiles and cater to specific investor preferences.

American Options: A Refresher

Before delving into the transformation process, let’s revisit the core features of standard American options. These options grant the holder the right (but not the obligation) to exercise the option at any point up to and including the expiration date. This flexibility to exercise early adds a layer of complexity compared to European options, which can only be exercised at expiration.

Modifying American Options: Examples and Strategies

The transformation of standard American options involves altering key parameters to create nonstandard variations. One common modification is adjusting the strike price. By selecting a new strike price, investors can create in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM) nonstandard American options. For instance, transforming an ITM option could allow an investor to gain exposure to a larger price movement while maintaining the flexibility to exercise early.

Example 1: Transforming an ITM Option

Consider an investor holding an ITM standard American call option on Stock XYZ with a strike price of USD 100. The stock’s current price is USD 110. By modifying the option to have a higher strike price, say USD 120, the investor creates a nonstandard option that captures a larger potential price movement between USD 110 and USD 120, while still retaining the early exercise feature.

Example 2: Adjusting the Expiration

Another approach involves adjusting the expiration date. Extending or shortening the time to expiration can impact the option’s value and risk exposure. Investors seeking to capitalize on short-term events may opt for a shorter expiration, while those anticipating longer-term trends might prefer an extended expiration.

Suppose an investor holds a standard American put option on Commodity ABC, expiring in three months. If the investor expects a significant market-moving event in the next month, they could modify the option to have an expiration of one month. This would allow them to focus on the specific short-term event and potentially maximize their gains.

Nonstandard American Options: Advantages and Risks

Transforming standard American options into nonstandard variations offers several advantages, such as tailored risk exposure, enhanced profit potential, and strategic positioning. However, along with these benefits come inherent risks. Nonstandard options can amplify both gains and losses, and their complexity requires a deeper understanding of market dynamics and timing.