• 5 Really Exotic Options

    Published on September 16, 2013 with 5 comments

    Usually traded over the counter (OTC), exotic options have special conditions attached to them that meet the individual needs of investors.

    Standard options (vanilla options) are normal call and put options with standard terms, strike prices, and maturity dates applied to them. Though highly traded and on market, they are restricted as to their flexibility.

    Exotic options have special conditions attached to them that meet the individual needs of investors.Exotic options are often customized to investor needs. Because of their flexibility they tend not to have a standardized pricing mechanism, and are generally more expensive than vanilla options (though not always).

    For ease of explanation, the following five exotic options will be explained as call options (unless otherwise stated). Of course, if you believe an asset is going to fall, you should buy the relevant put options.

    1) LookBack Options

    Imagine that you bought shares at $50 and they moved to $70, but, rather than take the profit, you decided to hold on to see if the price would move higher. Suddenly the share price collapses to $40. You are left thinking, 'if only I had sold at $70'.

    Similarly, if you watch a share price move from $50 to $100, but had not bought any shares, you would probably think to yourself, 'if only I had bought them at $50'.

    In other words, with hindsight you would have acted differently, in the first instance selling at $70 stock you had bought at $50, and in the second buying stock at $50 that you could now sell at $100. Hindsight is the best trader in the world! LookBack options allow you to trade with hindsight. At the time of expiry, you can look back at the price action and exercise the option at the most advantageous price.

    Fixed Strike LookBack Options

    These pay the difference between the strike price and the highest price achieved in the market during the lifetime of the option.

    Example

    With the price of ABC shares at $100, you buy a fixed strike lookback call option with a strike price of $100. The share price rises to $120, before falling to $80 at the time of expiry of the option. At this time, and in this example, a plain vanilla option would be worthless. However, with the lookback option, you can exercise and take the profit of $20 (the difference between the strike price of $100 and the highest lifetime price of the underlying asset of $120).

    Fixed Strike LookBack options are always settled in cash-- you never end up with shares of ABC at the end.

    Floating Strike LookBack Option

    Floating strike price lookback options completely remove the need to time the market.This type of lookback option allows you to profit from the widest price difference seen during the lifetime of the option. Whereas fixed strike price lookback call options negate the need to time a market exit, these completely remove the need to time the market (save for the expiry date).

    Example

    With ABC's share price at $100, you buy a floating strike lookback call option. The share price falls to $80 before rising to $120. At the time of expiry, the underlying share price is $90. You can exercise the option at the high price of $120 with a strike price of $80, giving you a $50 profit.

    Floating strike lookback options allow the holder to buy the underlying shares at the lowest price seen during the option lifetime instead of cash settlement if wanted.

    While lookback options take away the problem of market timing, this flexibility comes at a price and the premium can be expensive. Flexibility comes at a price. If the underlying security does not move by enough, then the premium paid for the option could wipe out any potential profit.

    2) Barrier Options

    Barrier options can be 'knock-in' or 'knock-out', and work like vanilla options except they are activated, or de-activated, according to a pre-set barrier price.

    Knock-In

    These become active when the price of the underlying asset crosses a pre-determined price (the barrier). If this price is not breached, then the option will expire worthless, regardless of the price of the underlying asset.

    Example

    A knock-in call option, with a strike price of $50 and a knock-in barrier of $60 is bought when the price of the underlying asset is $40. If the price of the underlying asset rises to $58 at expiry, but has not crossed the $60 knock-in barrier, the option expires worthless. If the underlying price has crossed the barrier level during the lifetime of the option, then the option may be exercised at the strike price of $50.

    Knock-Out

    These become inactive when the underlying price of the asset crosses a pre-determined barrier price. If the knock-out barrier is breached, the option becomes worthless.

    Example

    When an asset is priced at $45, you buy a knock-out barrier call option with a strike price of $50 and a knock-out barrier of $55. Now, if the price of the underlying asset rises above $55 the option becomes worthless, irrespective of price at the time of expiry.

    Knock-ins are used by those investors expecting a large market move, while knock-outs are used by those expecting far smaller moves.

    There are four types of barrier options:
    Up and in, as the knock-in described above;
    Up and out, as in the knock-out described above;
    Down and in, in which the asset needs to move down and below the barrier price for the option to become active;
    Down and out; where the option becomes deactivated if the price moves down and below the barrier price.

    It is possible to trade a Double Barrier Option, sometimes known as a double knock out option. The price of the underlying asset must remain between the up-and-out barrier and the down-and-out barrier for the option to remain active. Such a position acts like a short straddle, though at a far cheaper premium.

    Barrier options are far cheaper than vanilla options, though the risk of the option expiring worthless is greater. Their lower cost can result in far higher profits than achievable with vanilla options.

    3) Asian Options

    Asian options can be cheaper than vanilla options, because through the averaging process the volatility is decreased.These were first introduced in Japan in 1987 and seek to eliminate the possibility of market manipulation on the underlying price of an asset at expiration time. Rather than using the price of the underlying asset at the time of expiry of an option, the maturity price of the asset is calculated by reference to a pre-determined averaging process. Asian options can be cheaper than vanilla options, because through the averaging process the associated volatility of the underlying asset is decreased.

    As well as the exercise price being averaged, some Asian options have an averaged strike price rather than a fixed strike price.

    4) Outperformance Options

    For investors who believe one asset will perform better than a second, an outperformance option is a more efficient way to trade a traditional pair. The holder receives the amount of the outperformance of one asset over another, multiplied by the nominal investment. If the asset selected as the outperformer does not outperform the second asset, then the option expires with no value.

    An example is if an investor expects the Dow Jones Industrial Index to outperform the Nasdaq 100, he should buy the outperformance option which pays a the notional multiplied by the outperformance of the Dow as against the Nasdaq.
    The pricing of such options are calculated by reference to the correlation between the two assets.

    5) Cliquet Options

    With a Cliquet Option, the strike price is reset at pre-determined and regular intervals on its way to its final expiration date. As each reset date is reached, the option will expire worthless if the price of the underlying security is below the strike price. The option is then 'reopened' with the strike price set to the lower security price.

    On the other hand, if the security price is higher than the strike price at the date of the reset, then the investor recieves the difference between the strike and the security pirce, and the strike price is reset to the new higher security price.

    Example

    An investor opens a three year cliquet option in ABC with a strike price of $100 and annual resetting.
    The first anniversary of the option is reached and the share price is $120. The investor will receive a $20 pay out, and the strike price is reset to $120.

    On the second anniversary, the share price has fallen to $110. The investor receives no pay out, and the strike price is reset to $110.

    At final expiry date, the final pay out will depend upon the final price of the underlying security. In this example, an underlying asset price below $110 means that the option will expire with no further pay out, and a price above that level will be reflected in a final pay out.

    This type of option is sometimes called a ratchet option.


    Related Articles

  • Forex Trading 101
  • Options Strategy: Short Straddle
  • What Are Lookback Options?


  • Comments

  • Quark     September 16, 2013 at 8:00 am

    Great stuff! Thanks Michael!

  • berti     September 16, 2013 at 8:24 am

    well explained, thanks!

  • PresidentNoyIl     September 16, 2013 at 10:31 am

    I really do not appreciate these exotic options, if only for the fact that they are more or less very expensive for me to get into. I really donít want to pay more and to be honest who here actually sells their options before maturity?

  • ZenInvesting     September 16, 2013 at 6:59 pm

    Thanks for the rundown here, I think that this is a great introduction into exotic options. Especially for someone like myself who has been shopping around for something better than standard options.

  • mirasol     September 17, 2013 at 6:45 am

    Definitely looking into Asian options now. Thanks for the heads up!

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