Exotic Options
We will cover following topics
Introduction
Exotic options, a subset of derivative products, offer investors unique opportunities to tailor their risk-reward profiles to specific market conditions and strategic goals. Unlike plain vanilla options, which have standardized terms, exotic options come with diverse characteristics and complex payoff structures that often depend on specific conditions or events. In this chapter, we delve into the various types of exotic options, exploring their distinctive features and examining how their payoff structures can create versatile investment opportunities.
Gap Options
Gap options are a type of exotic option that pay out based on the difference between the underlying asset’s price and a predetermined reference price, known as the “gap.” If the asset’s price falls within the gap, the option may pay out, otherwise, it expires worthless. Gap options are particularly useful for investors anticipating high volatility or uncertain market movements. For example, a “down and out” gap call option might provide a payout only if the underlying asset’s price drops by a certain percentage within a specified time frame.
Forward Start Options
Forward start options allow investors to delay the activation of the option until a predetermined future date. This feature enables investors to align their options with anticipated market trends or specific events. An example is a forward start call option on a commodity. An investor might use this type of option to capitalize on an expected increase in commodity prices without immediate exposure to current market volatility.
Compound Options
Compound options are options on options, offering investors the right but not the obligation to enter into another option at a later date. These options add a layer of complexity to derivative strategies, allowing investors to gain exposure to multiple market movements. For instance, an investor might purchase a call option on a call option, giving them the right to buy a regular call option at a later date at a predetermined strike price.
Chooser Options
Chooser options provide investors with the flexibility to choose between two distinct option structures at a predetermined future date. This option type is particularly useful when market conditions are uncertain. For instance, a chooser option might offer the choice between a call and a put option. Depending on market movements, the investor can select the more favorable option at the designated time.
Barrier Options
Barrier options come with a specific price level, known as the barrier, that triggers changes in the option’s payoff structure. If the underlying asset’s price reaches or crosses the barrier, the option’s characteristics can change, leading to early exercise or a different payout. For example, a “knock-in” barrier option might only become active if the underlying asset’s price crosses a certain level, creating unique opportunities for investors.
Binary Options
Binary options offer a fixed payout if the option’s condition is met, otherwise, there’s no payout. These options are characterized by their “all or nothing” nature. For example, a binary call option might pay out a fixed amount if the underlying asset’s price is above a certain level at the option’s expiration. Otherwise, the option expires worthless.
Lookback Options
Lookback options offer investors the advantage of retrospectively selecting the optimal exercise price during the option’s lifespan. These options account for the highest or lowest price of the underlying asset, allowing investors to maximize their gains. A lookback call option might provide the right to buy the asset at its lowest price within a specified period, maximizing potential profits.
Asian Options
Asian options calculate the average price of the underlying asset over a specific period. This averaging mechanism can mitigate the impact of short-term market volatility. An Asian call option might determine the average price of the asset over a month and provide a payout if this average exceeds a predetermined level.
Exchange Options: Cross-Currency and Cross-Asset
Exchange options involve the exchange of one asset or currency for another at a predetermined rate. These options provide exposure to multiple assets or currencies, making them suitable for investors seeking diversification. An exchange option might allow an investor to exchange a certain amount of currency A for currency B at a fixed exchange rate.
Basket Options: Multiple Underlying Assets and Risks
Basket options involve a portfolio of underlying assets rather than just one. The payoff of a basket option depends on the collective performance of the assets in the portfolio. This option type is valuable for managing risk and capturing broader market movements. For example, a basket call option might provide a payout if the average performance of a portfolio of stocks exceeds a specified level.
Conclusion
Exotic options introduce a world of diverse strategies and opportunities to investors looking to customize their risk profiles and capitalize on specific market conditions. From gap options that leverage price differentials to basket options that incorporate multiple assets, each exotic option type presents its own distinctive characteristics and potential benefits. Understanding the intricacies of these options is essential for making informed investment decisions in an increasingly complex financial landscape.