exotic options explained

What are exotic options?

The OTC markets (Over The Counter) are a constant source of financial innovations that are trying to adapt the characteristics of the different instruments to the specific needs of hedge of different economic agents such as traders. In the case of financial options, one of the most interesting innovations that have emerged in recent years is the exotic type, which can be subdivided into four types:

  • Compound options or options on options.
  • Options with dependent value on the historical evolution of the underlying asset (path-dependents).
  • Conditional Options.
  • Options based on several underlying assets.

Compound options

A compound option is an option whose underlying asset is another options contract. Therefore, there are four types of compound options:

  • Call on a Call
  • Call on a Put
  • Put on a Call
  • Put on a Put

Also, compound options can be European or American, but their markets are dominated by European compound option trading.

Such options are commonly used in currency markets to hedge risks conditional exchange such as the exchange risk arising from obtaining a supply contract in a foreign country. Before knowing the supply contract award, all bidders have a conditional exchange risk, so they may be interested use a  Call Option over a Put Option based in a currency to eliminate this risk. The success in the financial world of this type of contract is due in part to the higher level of leverage that provides compared to traditional options. For this reason, there is a significant demand by speculators in different markets.

Options with value dependent on the historical evolution of the underlying asset (path-dependents).

This type of options are subdivided into:

  • Lookback options.
  • Barrier options.
  • Double barrier options.
  • Asian options.

Lookback options.

Within lookback options there are two types:

  • Lookback options with floating strike price: in these options, the value of the exercise price is determined taking into account the most favorable price of the underlying asset over the lifetime of the option. In the case of call options, the strike price is the minimum while in the case of put options the strike will be the maximum price.
  • Lookback options with fixed exercise price: in this case, the final value of the underlying asset is determined taking into account the most favorable price of the underlying over the life of the option. The final price of the underlying asset is the maximum observed during the life of the option in the case of call options, while the put options the final price of the underlying asset will be the minimum observed during the life of the option.

Barrier options

Barrier options may be, within the field of exotic options, the most popular. Barrier options are options to acquire or lose effectiveness as the underlying asset price reaches a certain barrier level during the life of the option. In some cases, it is possible that if the option is disabled (or not activated), the buyer of the option is compensated with an amount called a rebate. We can set different possibilities when designing a barrier option:

– Down: When the barrier is below the underlying asset at the time of purchase the option. – Up: When the level of the barrier is above the underlying asset at the time of purchase the option. – In: In the event that the option is activated when the price of the underlying asset touches the barrier. – Out: In the event that the option is disabled if the price o the underlying asset touches the barrier.

Combining these possibilities, we can build different types of barrier options. Thus, for example, a barrier option put down-and-out, is a put option that will be disabled if it touches the barrier, which is below the underlying asset at the time of purchasing the option. Barrier options offer an excellent alternative to cover risks at critical levels of prices as they are cheaper than traditional options that are out of money.

Double barrier options

Double barrier options are similar to the Barrier options. The only difference is that the final value of the option depends on if the underlying asset touch (or not) an upper barrier and another lower barrier that form a range with the first one. There are four types of double barrier options:

  • Call up-and-out-down-and-out: if the underlying asset touches the lower or higher barrier the option is disabled.
  • Call-in up-and-down-and-in: if the underlying asset touches either barrier the option is activated.
  • Put up-and-out-down-and-out: if the underlying asset touches the lower or higher barrier the option is disabled.
  • Put up-and-in-down-and-in: if the underlying asset touches either barriers the option is activated.

Asian Options

The final value of such options is obtained by the arithmetic mean (or geometric) price of the underlying asset at a specified prior period before the expiration of the option. Generally, the average is calculated based on the daily closing prices of the underlying. In the OTC markets is very common that the deadline for the calculation begins at the time the option is created and close to maturity, although there is no technical problem to use another convention (eg, the average price of the month, quarter, etc., prior to maturity).

The fundamental purpose of such options is to reduce the potential for manipulation of the price of the underlying on the expiration date. Also, some investors see them as useful as its policy of purchases (or sales) are forced to make frequent transactions in the same assets at a given time horizon. Against the alternative of buying several different maturity options, it is cheaper to buy an Asian option with maturity at the end of the period, achieving a similar level of risk coverage.

Conditional options

These are options that incorporate a condition to execute the payment at maturity. Are divided into:

  • Forward Start Options.
  • Options with Extendible Expiration.
  • Binary Options.
  • Choose Options.

Forward Start Options

A forward start option is an option that starts at a future date. These options are often used in companies that have as an incentive system for employees, the use of stock options of the company. Normally these options start at a certain percentage in or out of money. If less than unity, the call option (put) starts in the money (out the money). If it is equal to unity, the option will begin in the money, and finally, if the value is greater than unity, the call option (put) will start out of the money (in money).

Options with Extendible Expiration

The options with extendable expiration are those options that can be exercised on the date initially planned but which may extend to any future if the option on the original expiration date is out of money.

Binary Options

Binary options, also known as digital options are very popular in the OTC markets to speculate or make coverage. They are also often used for the construction of more complex products (structured products). There are several types of digital options, and the most common are the following:

  1. Gap options.
  2. Cash or nothing options.
  3. Asset or nothing options.
  4. Cash or nothing options of two assets.
Gap Options

A gap option is an option where the strike determines the payment at maturity of the option. Perhaps you will better understand this type of options with an example: suppose the case of a gap call option gap with and strike of 100 which pays $100 on the condition that the difference between the strike and the underlying price at maturity (gap) is more than 20, in case there is no such difference then there is no payment at maturity.

Cash or nothing options

A cash or nothing option is one that pays a specified amount (or nothing) on the due date if the option ends in the money. In the case of a cash or nothing call option, it pays an amount if the underlying is above the strike at maturity, whereas in the case of a cash or nothing put option is the opposite.

Asset or nothing options

The payment at maturity of these options depends on if the option finishes in the money or not. If so, these options pay the price of the underlying asset.

Cash or nothing options on two assets

One type of binary option that are more complex is the cash or nothing options on two assets. There are four types of these options:

  1. Cash or nothing call options on two assets: These options pay a fixed amount if the underlying asset 1 is above the strike 1 and the underlying asset 2  is also above the strike 2 on the due date.
  2. Cash or nothing put options on two assets: These options pay a fixed amount if the underlying asset 1 is below the strike 1 and the underlying asset 2  is also below the strike 2 on the due date.
  3. Cash or nothing up-down options on two assets: In this case, the option pays a fixed amount if the underlying asset 1 is above the strike 1 and the underlying asset 2  is also above the strike 2 on the due date.
  4. Cash or nothing down-up options on two assets: These binary options pay a fixed amount if the underlying asset 1 is below the strike 1 and the underlying asset 2  is also below the strike 2 on the due date.

Chooser Options

Chooser options are those that offer the option buyer the possibility to choose at a given date between a call option or a put option. There are two types of chooser options, simple and complex. The simple type offer to the potential buyer of the option, the possibility to choose on a particular date between a call or put option with the same characteristics, ie same strike, and the same expiration date. In the case of complex chooser options, these offer the potential buyer of the option the possibility to choose between a call and a put option with different strikes and expiration dates.

Options based on two underlying assets

Within this type, there are many types of options. The most common are:

  • Options based on the exchange of two assets.
  • Options based on two correlated assets.
  • Options based on the maximum and minimum of two assets.

Options on the exchange of two assets

Its operation is very simple: the buyer of an option on the exchange of two assets acquired the right to exchange the asset 2 for asset 1 on the due date.

Options on two correlated assets

The options on two correlated assets are very common in the performance of investment portfolios coverage when there are adverse movements in asset prices. So, it is quite common the use of such options on two stock indexes or on a stock index and an exchange rate.

Options on the maximum and minimum of two active

The options on the maximum and minimum of two assets are characterized because they pay the maximum or minimum of two assets. That is, the buyer of a call option on the maximum (minimum) of two assets acquired the right to purchase on the date of expiry of the option the underlying value of the maximum (minimum) of the two assets. On the other hand, the buyer of the put option on the maximum (minimum) of two assets acquired the right to sell on the expiration date of the option the underlying value of the maximum (minimum) of the two assets.

Therefore, we have four types of these options:

  1. Call Option on the minimum of two assets. The option buyer acquires the right to buy the underlying asset with the lowest price on the date of the expiry of the option.
  2. Call Option on the maximum of two assets. The option buyer acquires the right to buy the underlying asset with the highest price on the date of the expiry of the option.
  3. Put Option on the minimum of two assets. The option buyer acquires the right to sell the underlying asset with the lowest price on the date of the expiry of the option.
  4. Put Option on the maximum of two assets. The option buyer acquires the right to sell the underlying asset with the highest price on the date of the expiry of the option.