Exotic Options

In the over-the-counter (OTC) market , virtually every term of option contracts is negotiated, but this greatly reduces liquidity of the option. To increase liquidity and trading activity, organized exchanges standardized the terms of option contracts, such as the number of shares that each contract represents, or the strike prices that are allowable. Most option contracts traded on exchanges are just called puts and calls; the trader simply specifies strike price, expiration month, and quantity. However, some contracts differ significantly from the standardized options traded on exchanges, but with terms common enough to warrant their own names, grouped under the genus exotic options, to contrast them from the standardized vanilla options, sometimes called more verbosely as plain-vanilla options.

Exotic options, traded in the OTC market, are either variations of the simple call and put options traded on organized exchanges, and usually have a European-style exercise option, when the option can only be exercised at or near the end of the contract term, or they are structured products with an optional component. Structured products are financial instruments that were created to satisfy a need for hedging under specific circumstances, and usually involves the use of derivatives.

Most exotic options are foreign-exchange options (aka FX options), and provide better hedging characteristics for certain business activities involving foreign exchange, but may be used by speculators for profit as well. Most FX options involve currency pairs where at least 1 of the currencies is a minor currency. Some of these options may be extremely volatile because of economic instability or political unrest in the country of the minor currency. The following explains the most common exotic options, but is, by no means, a complete list.

Basket options give the holder the right to receive 2 or more foreign currencies for a base currency for a designated or spot rate.

Compound options are options on options that give the holder the right to acquire another option by a specific date and for a specific premium. There are calls on calls, puts on puts, calls on puts, and puts on calls. Compound options are used by corporations to hedge foreign exchange risk for a business venture that may or may not occur.

Bermuda options have an exercise option that is somewhat between that of American- and European-style options. (Supposedly, the name Bermuda derives from the island's location between the United States and Europe.) Whereas an American-style option can be exercised any time before expiration and a European option can only be exercised on or near the expiration date, a Bermuda option can only be exercised on specific days before expiration or on the expiration date. For instance, a Bermuda option may allow exercise only on the 1st day of each month before expiration, or on expiration.

Binary options (aka: digital options, fixed-return options, all-or-nothing options, cash-or-nothing options, asset-or-nothing options) are so-called because their payouts depend on whether a condition is true or false, with the false condition usually paying nothing to the holder of the binary option. Every other characteristic of a binary option depends on the contract on which it is based, which, in turn, depends on the writer of the contract, or, with a standardized contract, upon the standard set by an exchange. In the United States, most exchange traded binary options pay either $0 or $100 at expiration. Most binary options are not classified as puts or calls. Although there are exceptions, little is gained by classifying a binary option as a put or call since each option has only 2 possible values at expiration. Instead, a typical binary option is in the money if the price of the underlying is either at the strike price or above. If the binary option remains in the money at expiration, then the holder of the binary option receives $100; if the price of the underlying is below the strike price at expiration, then the long position receives nothing, and the binary option writer — the short position — gets to keep the premium for selling the option; otherwise, the short position must pay the long position $100, requiring the short trader to pay an additional amount equal to $100 minus the premium received for selling the option, which is the maximum amount that the short trader can lose in the transaction. The maximum potential loss for the long trader is the premium paid for the option. The value of the binary option will vary from $0 to $100 before expiration, depending on how close the value of the underlying asset was to the strike price and on how much time remained until expiration. So if a trader sold a binary option for $25, and the option expires in the money, then the trader must pay an additional $75 to settle the trade. The trader who bought the option for $25 would earn a profit of $75, equal to the $100 payout minus the $25 paid for the option. If the trader expected the price of the underlying asset to decline, then, rather than buying a put, the trader would simply sell the binary option, taking the short position. If the trader expected the price to increase beyond a certain level by a certain time, then the trader would buy the binary option with a strike price equal to the minimum expected price at expiration. Before trading binary options, read this: Investor Alert: Binary Options and Fraud | Investor.gov.

A diagram showing the payoff of a binary option at expiration.
A diagram showing the payoff of a binary option at expiration.

Best-of-two options depends on 2 different securities or indexes; and better-of-two options pays off according to the better performing security or index.

An Asian option (synonyms: average rate option, average price option) pays according to the average value of the underlying during the contract period. A business would use this option to hedge against price increases or decreases over a certain period, but must buy and sell the underlying asset every day or more frequently than the available expiration dates for options or futures. Asian options pay off according to the following formula:

Average Price = Maximum (Average Spot Price – Strike Price, or 0).

A ladder option (synonyms: step-lock option) allows the holder to lock in gains in the underlying during the contract period.

A lookback option pays according to the highest value reached by the underlying during the contract period. Some lookback 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:

Lookback = Maximum (Spot Price at Expiration – Minimum Spot Price over Term of Contract, or 0).

Another formula for the lookback uses the lowest value for the spot price.

Lookback = Maximum (Maximum Spot Price – Strike Price, or 0).

A lock-out option pays if the value of the underlying does not go beyond a specified value. A double-lockout option pays if the value of the underlying asset remains confined within a specified range. For instance, a double-lockout option might pay if the currency pair USD/CHF trades within 1.22 and 1.24 during the term of the contract. If USD/CHF trades either above or below this range at any time during the term of the contract, then it pays nothing. A range-accrual option is similar, but it pays according to how many days the value of the underlying asset was above or below a specified value, or was confined within a specified range.

Barrier options pay off if an asset reaches a certain price. Knock-in options are created with predetermined characteristics when the underlying reaches a certain price. Knock-out options are options that terminate if the underlying reaches a certain price. Since the option ceases to exist, there is no payoff even if the price moves back within the knock-out barrier before the original expiration. Thus, an option with a knock-out barrier has a maximum specified value and payoff.

Graphs of a call option and a put option with a knock-out barrier.

Single-barrier options have a single trigger price that is either above or below the strike price, and 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 standard options, with the double-barrier option being cheapest. Most exotic FX options are barrier options.

A double-trigger option, often used for insurance purposes, pays off only if 2 events occur. A company or an insurance company will buy this option to limit losses that are very unlikely, but would be very expensive if they both occurred. An example would be if a company had a large property loss in a foreign country where changes in the foreign exchange rate made the loss much more expensive.

Weather options pay off 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.