Exotic Options Trading
If you already know the ins and outs of vanilla options well, taking a step into the world of exotic options might be the right thing for you if you are looking to spice up your investment portfolio and is willing to do your homework.
The term exotic option is used for all those options that for one reason or another does not fit the mould of standardized vanilla options. Within the exotic options category, you will find a wide range of different options and many of them have actually been created with a specific buyer in mind rather than being general-purpose investment instruments. Some exotic options are issued and tailormade to solve a very specific situation, but there are also more run-of-them-mill exotic options that are sold and bought in a fashion similar to vanilla options.
Exotic options are used for both speculation and to manage risk for other investments. Pricing exotic options are notoriously difficult and this in turn frequently gives rise to arbitrage opportunities, a fact that has not gone unnoticed by sophisticated quantitative investors on the options market.
Below, we will take a look at a few different barrier options. This is just one of many subcategories within the large and heterogeneous exotic option category. Barrier options are options that can activate or deactivate based on the movements of the underlying.
The knock-out option – one example of a barrier option
A knocked-out option is extinguished (”knocked-out”) if the price of the underlying hits a certain pre-determined point.
This knock-out stock option has a strike price of 40 USD and a knock-out price of 50 USD. If the stock price reaches 50 USD, the option will stop being a valid options contract. It will automatically become worthless since it can no longer be exercised.
The knock-out option in the example above is an example of an up-and-out call option since it is a call option that deactivates when the price rises to a specific level.
This up-and-out knock-out feature limits the risk for the writer of the call option, and it also caps the possible profit for the holder of the option. Because of this, an up-and-out knock-out call option is typically considerably cheaper to buy than an option without the knock-out feature (ceteris paribus).
The knock-out option is a type of barrier option. Just as for other barrier options, the price of a knock-out option tends to jump up or down in big leaps rather than creep steadily in a direction. Barrier options often have a foreign exchange or equity as the underlying asset, but could be written for pretty much any type of underlying instrument. They are ideally suited for hedging and are for instance used by companies that need to protect themselves from dramatic price movements on the commodity market.
What is a down-and-out option?
The down-and-out option is a type of knock-out option where the option deactivates if the price of the underlying drops down to a certain level.
The knock-in option is another example of a barrier option. Instead of being knocked out if the underlying reaches a certain price, this option doesn´t get activated (”knocked-in”) until the underlying reaches a certain price.
This knock-in call stock option has a strike price of 90 USD and a knock-in price of 100 USD. As long as the underlying share price is below 100 USD, the option is inactive. If the share price reaches 100 USD, the option becomes activated. Since the strike price is 90 USD, the call option (”right-to-buy option”) in this scenario is already 10 USD in the money when it activates.
The knock-in option in the example above is an example of an up-and-in option since it activates when the price rises to a specific level.
What is a down-and-in option?
The down-and-in option is a type of knock-in option where the option activates if the price of the underlying drops down to a certain level.
Final thoughts about exotic options
The options listed above are only a small sample of the many types of exotic options that are available on the financial markets today. There are dozens of different types of exotic options that are readily available on the market. Among them, you sometimes find the binary option listed. The binary option is not a true option but rather a financial game that was first developed by gambling operators. Binary options are designed to guarantee that the broker that issues to option will earn money. There is no third party involved when trading binary options, the broker assumes the opposite position. You should never trade binary options. You are almost guaranteed to lose money.
You might also encounter bespoke exotic options. Options that were designed at the request of the issuer and that works differently from all other types of exotic options. It is therefore essential that you make sure to research all exotic options before you decide to invest your money in them. You need to understand exactly how they work when they mature and how they are settled before you invest in any exotic or over-the-counter options. You need to do this for each and every option you want to invest in. If you do not want to have to do this then you should only trade exchange-traded options. Exchange-traded options are more standardized and you need to do less work. Do not invest in exotic or over-the-counter options unless you are willing to devote yourself to the trade.
Exotic options can be a very useful financial tool that allows you to hedge your trades and increase your ability to earn money from different market conditions. But they are not for novice traders and should only be used by traders who know how to use them correctly. 99% of all traders are better off avoiding exotic options. Only you can say if you are one of the 1% that would benefit from using them.