Sharekhan Blog

What are Exotic Options?

  • Apr 18, 2024

An exotic option is a contract containing attributes that are not common to most of the contracts. This results in complicated valuation schemes. It is the exact opposite of the Plain Vanilla Scheme.

Exotic Option vs. Traditional Option

An Exotic option has non-standard payout structures or other features. These are mostly traded in over-the-counter markets and have complex criteria that affect the valuation and payoff. Sometimes, they are time-sensitive and allow the holder to exercise specific preferences at various points before the expiration date.

Examples of exotic options include Asian Option, where the strike Price is based on the projected average price of the underlying asset, and the compound option, where the underlying asset is another Option.

Types of Exotic Options

There are 5 types of Exotic Options:

1.Barrier Options

These are Option contracts where the payoff depends on whether or not the price of the underlying asset crosses a certain level during the Option’s lifetime. When barrier Options are sold, they are created with a specified expiration date, a strike price and a barrier price.

Barrier Options are of four types.

  • Down-and-out barrier Options
  • Down-and-in barrier Options
  • Up-and-out barrier Options
  • Up-and-in barrier Options

2. Binary Options

These are Options that either pay a fixed amount depending on whether or not a certain condition is fulfilled when the Option expires. They are structured as European Options and are mainly Over-the-counter.

3.Look-back Options

These Options give the holder the right to buy or sell the underlying asset at its lowest or highest price. There are two types of look-back Options:

  • Fixed Look-back Options
  • Floating Look-back Options

4.Asian Options

The payouts of these Options depend on the average price of the underlying asset over a specified period of their lifetime.

5.Compound Options

The Option has another option underlying. The positions the trader can have are call on call, put on put, call on put, and put on call.

6.Chooser Option

The Option which allows a trader to choose whether the purchased Option is a call or a put after a specified time, is the Chooser Option.

Also Read about Guide to Selecting Best stocks for Options Trading

Intraday Exotic Options

Intraday exotic options are a subset of exotic options that are traded within the same trading day. The Key points include:

1. Intraday exotic options expire within the trading day. Thus, they demand quick decision-making.

2. The traders capitalise on short-term price movements to profit from intraday price fluctuations.

3. Compared to longer-term options, intraday options offer reduced time exposure, eliminating overnight risks.

4. Intraday trading often benefits from increased market activity, providing copious liquidity for executing trades.

Benefits and Risks of Exotic Options

Exotic Options offer a range of advantages and disadvantages for traders, which should be carefully understood before investing.

Benefits

  • Exotic Options provide flexibility that aligns with the trader's desired gains.
  • The customisable features allow for tailoring strategies to specific risk tolerances and market conditions, facilitating effective risk management strategies.
  • Exotic Options have the potential to generate increased returns compared to traditional Options.
  • They offer exposure to niche markets and provide traders with unique investment opportunities.
  • The innovative payoff structures can provide alternative avenues for profit.
  • They often come with lower premium costs in comparison to standard American Options.
  • Exotic Options can serve as solutions to situation-specific conditions, offering situation-specific solutions to complex market scenarios.

Risks

  • They are complex and are thus challenging to understand.
  • They demand a deep level of expertise for effective utilisation.
  • Exotic Options also tend to have lower liquidity than their vanilla alternatives, potentially leading to difficulties in executing trades at desired prices.
  • Valuing Exotic Options can be complex, which further complicates decision-making processes.
  • Over-the-counter trading with Exotic Options has counterparty risk, which may not be present in exchange-traded Options.
  • Some Exotic Options come with increased premium costs, reducing potential returns.
  • The gains from Exotic Options may only sometimes be maximised, and their price movements may show uncertainty.

Overall, while Exotic Options offer unique opportunities, they also come with inherent risks that require careful consideration and management.

Conclusion

Exotic Options present traders with unique opportunities but also carry inherent risks due to which they should be managed carefully. They facilitate effective risk management by offering flexible strategies that can be modified in accordance with individual preferences. Exotic Options have the potential to yield increased returns as compared to the traditional Options.

However, their complexity demands a deep understanding and may lead to challenges in valuation and liquidity. Counterparty risks in Over-the-counter trading and potential premium costs further add to the complexity. Although Exotic Options provide situation-specific solutions, traders must carefully evaluate these benefits, bearing in mind the accompanying risks so as to make well-informed decisions.

Team Sharekhan
by Team Sharekhan

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