What are Exotic Options?
Exotic options, distinct from conventional American and European options, feature unique payment terms, expiration dates, and strike prices. These financial derivatives are characterized by their intricate structures, offering increased investment possibilities. Unlike standard options, exotic options can be tailored to align with an investor’s risk preferences and financial objectives. Their non-standardized features make them highly customizable, allowing for precise adaptation to specific risk management or investment strategies.
Here are some benefits and limitations associated with Exotic options:
Benefits
- Flexibility: Exotic options can be customized to meet specific investment objectives.
- Risk Management: They allow investors to tailor their risk exposure more precisely, as exotic options can be designed to provide protection against specific market scenarios.
- Innovative Payoff Structures: Exotic options often come with innovative payoff structures, enabling investors to take advantage of unique market views.
- Access to Niche Markets: Some exotic options provide exposure to niche markets or specific asset classes that may not be easily accessible through traditional financial instruments.
- Enhanced Return Potential: Exotic options can offer increased return potential compared to standard options, especially in situations where unique market conditions are expected.
Limitations
- Complexity: Exotic options are more complex than standard options, making them challenging for many investors to understand and properly value.
- Higher Transaction Costs: Due to their complexity, exotic options may involve higher transaction costs, both in terms of fees and bid-ask spreads.
- Limited Liquidity: Exotic options are often less liquid than standard options, which can make it difficult to enter or exit positions, potentially impacting the ability to manage risk.
- Valuation Challenges: The valuation of exotic options can be more complex, requiring sophisticated models and potentially leading to uncertainties in pricing.
- Counterparty Risk: Exotic options are often traded over the counter (OTC), exposing investors to counterparty risk. This risk arises if the counterparty fails to fulfill its financial obligations.
Types of Exotic Options
Let’s explore the valuation methods for some common exotic options:
- Barrier options – The main feature of barrier exotic options is that the contracts become activated only if the price of the underlying asset reaches a predetermined level.
- Asian options – The Asian option is one of the most commonly encountered types of exotic options. They are option contracts whose payoffs are determined by the average price of the underlying security over several predetermined periods of time.
- Lookback options – A type of exotic financial derivative that grants the holder the right, but not the obligation, to buy (call) or sell (put) the underlying asset at its lowest or highest price over a specified period
- Binary options – They are also known as digital options. The options guarantee the payoff based on the occurrence of a certain event. If the event has occurred, the payoff is a fixed amount or a predetermined asset. Conversely, if the event has not occurred, the payoff is nothing. In other words, binary options provide only all-or-nothing payoffs.
- Bermuda options – These are a combination of American and European options. Similar to European options, Bermuda options can be exercised at the date of their expiration. At the same time, these exotic options are also exercisable at predetermined dates between the purchase and expiration dates.
Barrier Options
Barrier options belong to the category of exotic options and possess a distinctive feature tied to a specific price level, known as the barrier. The key characteristic of barrier options is that the option is either activated or deactivated when the underlying asset’s price reaches the predetermined barrier level.
These options introduce an additional layer of complexity by incorporating a specified barrier, which serves as a trigger for a particular action related to the option. The barrier can act as a threshold, influencing the behavior of the option when crossed. Depending on the type of barrier option, reaching the barrier can lead to the initiation or termination of the option contract.
Types of Barrier Options
- Knock-in – A knock-in option falls under the category of barrier options, characterized by the activation of associated rights contingent upon the underlying security’s price reaching a specified barrier during the option’s lifespan. The knock-in feature signifies that the option’s rights materialize or “knock-in” only when the predetermined barrier is breached, and once initiated, the option remains active until it reaches expiration. There are two primary classifications of knock-in options: up-and-in and down-and-in. In the case of an up-and-in barrier option, the option becomes effective solely if the underlying asset’s price surpasses the pre-established barrier, which is positioned above the initial price of the underlying asset. Conversely, a down-and-in barrier option comes into play when the underlying asset’s price descends below a predetermined barrier, positioned beneath the initial price of the underlying asset. The knock-in mechanism introduces a conditional activation, adding a layer of complexity to the option’s lifecycle based on the specified price movements.
- Knock-out – Unlike knock-in barrier options, knock-out barrier options become null and void if the underlying asset touches a barrier at any point during the option’s duration. These options are further categorized as up-and-out or down-and-out. In the case of an up-and-out option, it terminates if the underlying security surpasses a barrier positioned above the initial price of the underlying asset. Conversely, a down-and-out option terminates if the underlying asset’s price falls below a barrier set beneath its initial price. The termination, or knock-out, occurs instantly if the underlying asset touches the barrier at any juncture throughout the option’s existence. This distinctive feature distinguishes knock-out barrier options from their knock-in counterparts.
Example
Knock-In Barrier Option
Suppose you have a knock-in call option with an initial stock price (S0) of ₹100, a strike price (K) of ₹105, and a knock-in barrier (H) of ₹120. The knock-in feature implies that the call option only becomes active (in existence) if the stock price rises above the barrier of ₹120 during the option’s life. If the stock price remains below ₹120, the option stays inactive.
– Initial stock price (S0): ₹100
– Strike price (K): ₹105
– Knock-in barrier (H): ₹120
If the stock price rises to ₹125 during the option’s life, the knock-in feature is triggered, and the call option becomes active. You can now exercise the option at the strike price of ₹105, potentially realizing a profit.
Knock-Out Barrier Option
Now, consider a knock-out put option with the same initial stock price (S0) of ₹100, a strike price (K) of ₹110, and a knock-out barrier (H) of ₹130. The knock-out feature implies that the put option will become null and void (knocked out) if the stock price rises above the barrier of ₹130 during the option’s life. If the stock price stays below ₹130, the option remains active.
– Initial stock price (S0): ₹100
– Strike price (K): ₹110
– Knock-out barrier (H): ₹130
If the stock price rises to ₹135 during the option’s life, the knock-out feature is triggered, and the put option becomes null and void. You cannot exercise the put option, potentially incurring a loss.
Graphical Representation
Here are some commonly used methods for pricing barrier options
- Closed-Form Solutions: These solutions provide explicit formulas for the option prices. However, closed-form solutions are relatively rare for barrier options.
- Finite Difference Methods: Finite difference methods discretize the space and time dimensions of the option pricing problem. The partial differential equation governing the option’s price evolution is then solved numerically.
- Monte Carlo Simulation: Monte Carlo simulation involves generating a large number of random price paths for the underlying asset and calculating the option payoff for each path. The average of these payoffs is then discounted to obtain the option price. Monte Carlo simulation is versatile and can handle complex barrier structures.
Benefits of Trading Barrier Options
The allure of barrier options lies in their distinctive conditions, often leading to more cost-effective premiums compared to similar options lacking such barriers. Consequently, traders inclined to believe that a specified barrier is improbable to be breached may find appeal in purchasing knock-out options. These options come with lower premiums, and the unlikely activation of the barrier condition makes them an attractive choice.
For those seeking to hedge a position but only under the condition that the underlying asset’s price reaches a specific level, the deployment of knock-in options becomes a strategic consideration. The reduced premium associated with barrier options adds to their attractiveness, presenting a more favorable alternative when compared to non-barrier American or European options. The incorporation of barriers introduces flexibility and cost-efficiency into trading strategies, aligning with diverse risk management objectives.
Asian Options
An Asian option, also referred to as an average option, is a distinctive financial derivative with a payoff contingent on the average price of the underlying asset during a designated time frame. Unlike conventional European or American options, which hinge on the asset’s price at a specific moment, Asian options derive their value from an averaged price over a predefined period.
The reliance on an average price makes Asian options less vulnerable to abrupt market fluctuations, providing investors with a more stable and smoothed-out metric for determining the option’s profitability. This unique characteristic distinguishes Asian options in the realm of financial derivatives, offering an alternative approach to managing risk and exposure in the dynamic landscape of financial markets.
Types of Asian Options
- Average Price Option (Fixed Strike): In the Average Price Option with a fixed strike, the strike price is established beforehand, and the payoff calculation is based on the averaged price of the underlying asset. This option type introduces a predetermined strike price, offering a unique approach to calculating potential payoffs.
- Average Strike Option (floating strike): The Average Strike Option, characterized by a floating strike, utilizes the average price of the underlying asset over a specified duration as the strike price. This option type introduces a dynamic strike price, offering a distinct method where the averaged price plays a pivotal role in determining the payoff.
Graphical Representation
Here are some commonly used methods for pricing Asian options:
Finite Difference Method
Finite Difference is a numerical technique used to solve partial differential equations governing the pricing of financial derivatives. In the context of Asian options, this method discretizes the underlying asset’s price and time, allowing for the approximation of the option’s value at various points. The discretization helps in handling the averaging feature inherent in Asian options, providing a numerical solution to the pricing equations.
Monte Carlo Simulation
Monte Carlo Simulation involves the generation of numerous random scenarios to model the potential outcomes of financial instruments. In the case of Asian options, Monte Carlo Simulation can be applied to simulate the random paths of the underlying asset’s price. By averaging the payoffs over these simulated paths, the expected value of the Asian option can be estimated. Monte Carlo methods are particularly effective for handling the stochastic nature of financial markets.
Benefits
- Reduced Volatility Impact: Averaging over a period can reduce the impact of short-term volatility on the option’s payoff.
- Lower Premiums: Asian options often have lower premiums compared to European or American options, making them attractive for risk management.
Challenges
- Complexity: The averaging mechanism introduces complexity, both in terms of understanding and pricing.
- Less Liquidity: Asian options are less liquid compared to standard options, making it challenging to find counterparties for trading.
- Pricing Challenges: Pricing Asian options can be more complex than pricing European or American options due to the need to model the average price.
Lookback Options
A lookback option is a specialized financial derivative whose payout is contingent on the extreme (either the highest or lowest) value attained by the underlying asset’s price throughout the entire duration of the option. What sets a lookback option apart is its unique feature that enables the holder to retrospectively evaluate the entire option period and choose the most advantageous price level to determine the option’s value. This stands in stark contrast to conventional options, where settlements are based on the spot price at a specific moment in time.
The primary characteristics of lookback options include:
- Historical Perspective: Lookback options provide the holder with the ability to survey the complete price history of the underlying asset during the option’s lifespan. This retrospective evaluation empowers the option holder to select the optimal price level, maximizing potential gains.
- Extreme Value Dependency: The payoff of a lookback option hinges on the extreme price reached by the underlying asset, whether it is the highest (for a call option) or the lowest (for a put option).
- Versatility: Lookback options offer versatility to investors by allowing them to benefit from favorable price movements while mitigating the impact of adverse fluctuations.
- Contrasting Settlement Mechanism: Unlike standard options, which settle based on the spot price at a predefined moment, lookback options introduce a dynamic settlement mechanism that considers the most advantageous historical price.
This distinctive feature makes lookback options a valuable tool for investors seeking flexibility and the potential for enhanced returns in dynamic and fluctuating financial markets.
Types of Lookback Options
- Fixed Strike Lookback Option: The strike price is predetermined and remains constant, and the payoff depends on the maximum or minimum asset price.
- Floating Strike Lookback Option: The strike price is determined at maturity based on the maximum or minimum asset price during the option period.
Examples
In example number one, assuming a stock trades at ₹50 at both the start and end of the three-month option contract, resulting in no net change, gain, or loss. The stock’s path remains the same for both the fixed and floating strike versions. At one point during the option’s life, the highest price is ₹60, and the lowest price is ₹40.
For a fixed strike lookback option, the strike price is ₹50. The best price during the lifespan is ₹60. At strike, the stock is ₹50. The profit for the call holder is ₹60 – ₹50 = ₹10.
For a floating strike lookback option, the lowest price during the lifespan is ₹40. At maturity, the stock is ₹50, which is the strike price. The holder’s profit is ₹50 – ₹40 = ₹10.
The profit is the same because the stock moved the same amount higher and lower during the life of the option.
In example number two, assuming the stock had the same high of ₹60 and low of ₹40 but closed at the end of the contract at ₹55, for a net gain of ₹5.
For a fixed strike lookback option, the highest price is ₹60. The strike price is ₹50, which was set at purchase. Profit is ₹10 (₹60 – ₹50 = ₹10).
For a floating strike lookback option, the strike price is ₹55, which is set at option maturity. The lowest price is ₹40. Making a profit of ₹15 (₹55 – ₹40 = ₹15).
Finally, in example number three, assuming the stock closed at ₹45 for a net loss of ₹5.
For a fixed strike lookback option, the highest price is ₹60. Less the strike price of ₹50, which was set at purchase. Gives a profit of ₹10 (₹60 – ₹50 = ₹10).
For a floating strike lookback option, the strike price is ₹45, which is set at option maturity. Less the lowest price of ₹40, Gives a profit of ₹5 (₹45 – ₹40 = ₹5).
Binary Options
A binary option is a financial instrument characterized by its binary nature, where the possible outcomes are limited to two based on the expiration result. The term “binary” reflects the simplicity of the option, relying on a straightforward “yes or no” proposition. If the binary option expires in the money, traders receive a payout, but if it expires out of the money, they incur a loss.
Example
Let’s consider an investor looking at a binary option on the performance of a technology stock XYZ. The current market price of XYZ is ₹80 per share. The binary option has a strike price of ₹85, and the investor believes that by the end of the trading day, XYZ’s stock price will be above ₹85.
Binary Option Details:
– Binary option worth 100 or 0
– Entry Price: The investor buys a binary option for ₹45.
– Expiry Time: The option expires at 4:00 p.m.
Potential Outcomes:
In the Money:
If, by 4:00 p.m., XYZ’s stock price is above ₹85, the binary option expires in the money.
Payout: The investor receives ₹100, making a profit of ₹55 (₹100 – ₹45).
Out of the Money:
If, by 4:00 p.m., XYZ’s stock price is below ₹85, the binary option expires out of the money.
Loss: The investor loses the entire ₹45 investment.
Pros
- Simplicity: Binary options are straightforward and easy to understand. Traders only need to predict whether the price of an underlying asset will go up or down within a specified period.
- Fixed Payouts: Binary options offer fixed payouts, known in advance. This feature can be appealing to traders who prefer knowing the potential profit or loss before entering a trade.
- Short-Term Trading: Binary options often have short expiry times, ranging from seconds to days. This can be attractive to traders looking for quick results and the opportunity to capitalize on short-term market movements.
Cons
Limited Profit Potential: Binary options offer fixed payouts, which means there is a cap on potential profits. Traders cannot benefit from extended price movements beyond the fixed payout.
Broker Dependence: Binary options trading relies on online brokers, and the trader’s experience may be influenced by the reliability and integrity of the chosen broker.
Lack of Flexibility: Binary options have limited flexibility compared to other trading instruments. Traders cannot customize the trade parameters, and options must expire within a set timeframe.
Market Manipulation: Binary options have been associated with potential market manipulation, and fraudulent activities have been reported. Traders need to choose reputable brokers to mitigate these risks.
Graphical Representation
Bermuda Options
A Bermuda option falls within the category of exotic options and possesses a distinctive feature – it is exercisable only on specific, predetermined dates. Unlike traditional American options, which grant the flexibility of early exercise at any time, Bermuda options limit this privilege to specific, scheduled dates, often occurring once a month.
Advantages and Disadvantages
Bermuda options present a unique set of advantages and disadvantages in the realm of financial derivatives. These options stand out by offering investors the opportunity to create and acquire hybrid contracts, providing a level of control over the exercise timeline. However, this benefit comes with specific considerations.
Advantages
- Control Over Exercise Timing: Unlike European options, Bermuda options grant investors more control over when the options can be exercised. This feature allows for strategic decision-making based on market conditions.
- Lower Premiums: Bermuda options typically come with lower premiums compared to American options. While American options offer greater flexibility, this added feature comes at a higher cost. Bermuda options strike a balance by providing flexibility at a relatively lower premium.
- Hybrid Contract Creation: Investors can benefit from the ability to create hybrid contracts with Bermuda options, combining elements of both American and European options based on their specific needs and preferences.
Disadvantages
- Limited Flexibility: Despite offering control over exercise timing, Bermuda options lack the full flexibility of American options. Investors must adhere to predetermined exercise dates, reducing the spontaneity of decision-making.
- Cost Positioning: While Bermuda options have lower premiums than American options, they are still costlier than European options. The cost positioning falls in between these two counterparts, making it essential for investors to weigh the benefits against the expenses.
- Suboptimal Exercise Dates: The predetermined exercise dates of Bermuda options may not always align with the most favorable market conditions. If an investor delays exercise until the option’s expiration date, they might realize suboptimal outcomes compared to choosing a cheaper European option.
In summary, Bermuda options offer a unique blend of control and cost considerations, making them a viable choice for investors seeking a middle ground between American and European option features.
Example
Let’s consider an investor holding shares in Infosys Ltd. The investor acquired the stock at ₹1,500 per share and desires protection against a potential decline in the company’s stock value.
The investor decides to purchase a Bermuda-style put option expiring in six months, featuring a strike price of ₹1,475. This option comes at a cost of ₹3 per share, totaling ₹300 for the entire option contract representing 100 shares. The purpose of this option is to safeguard the position from a price drop below ₹1,475 for the upcoming six months. Notably, the Bermuda characteristic allows the investor to exercise the option early on the first day of each month, starting from the fourth month.
As the stock price experiences a decline to ₹1,200, by the initial day of the option’s fourth month, the investor chooses to exercise the put option. The stock position, facing a decrease, is sold at ₹1,200. The strike price of ₹1,475 results in a profit of ₹275 from the put option. This showcases the flexibility provided by the Bermuda feature in adapting to changing market conditions.
Graphical Representation
