Exotic Options: Defination, Types & Differences

Exotic, non-standard, or complex options in option trading offer unique and specialised features beyond the basic “vanilla” options commonly traded on major exchanges. While traditional options give investors the right to buy or sell an underlying asset at a specified price and time, exotic options offer a wider range of possibilities and potential outcomes.

From barrier options to Asian options, a diverse range of exotic options cater to different option trading strategies and risk appetites. However, with their complexity and potential for higher returns also comes increased risk and a need for careful consideration and analysis.

This guide will discuss the meaning of exotic options, exploring their characteristics, uses, and risks to understand these intriguing option strategies.

What are Exotic Options?

Exotic options refer to a specialised category of financial derivatives that differ from standard options regarding their unique payoff structures, barriers, triggers, and conditions. These options meet specific investor needs and market views, offering a customised approach to trading and hedging strategies. Unlike plain vanilla options with straightforward payoffs based on the underlying asset’s price movement, exotic options introduce additional complexities and features.

One key differentiating factor of exotic options is the inclusion of barrier options. Barriers act as predetermined price levels that, if reached or breached, can determine whether the option becomes active or inactive. This feature allows investors to tailor their options based on their expectations of the underlying asset’s price movements.

They also incorporate triggers, which are additional conditions that must be met for the option to be exercised. These conditions can be based on factors such as time, volatility, or the performance of other financial instruments.

By introducing triggers, investors can create options that are more responsive to specific market conditions, enhancing their ability to manage risk and maximise potential returns.

Furthermore, they are commonly used in complex financial strategies that involve combinations of multiple options or other financial instruments. These strategies can generate income, hedge against potential losses, or capitalise on specific market scenarios. The customisation offered by exotic options allows investors to tailor their strategies according to their risk appetite, investment objectives, and market outlook.

Types of Exotic Options

Barrier options are exotic options that include a barrier price, which, if touched, can either activate or deactivate the option. There are two main types of barrier options: knock-in and knock-out options. Knock-in options become active when the barrier price is reached, allowing investors to participate in potential profits. On the other hand, knock-out options deactivate when the barrier price is breached, making the option worthless.

Digital options, also known as binary options, have a fixed payout if the option expires in the money, meaning the option’s condition is met. These options have a predetermined strike price and expiration date, and the investor can either receive a fixed payout if the condition is met or nothing at all if the condition is not met.

Asian options are exotic options where the payoff is determined by the average price of the underlying asset over a specific period. This option is often used to mitigate the impact of short-term price fluctuations and provide a more stable payoff.

Asian options can be either average rate or average strike options, depending on whether the average price is used to calculate the payout rate or the strike price.

Lookback options have a unique characteristic that allows the investor to “look back” over a specified period and choose the most favourable price for exercising the option. These options provide the potential for increased profits as they allow the investor to capture the highest or lowest price of the underlying asset during the observation period.

Basket options are exotic options based on a portfolio or basket of underlying assets rather than a single asset. The weighted average price of the assets in the basket determines the payoff of a basket option. This option offers diversification benefits and allows investors to capture the performance of multiple assets with a single contract.

An Example of Trading Exotic Options

Let’s assume Mr Sharma, an experienced investor in the Bombay Stock Exchange (BSE), holds a bullish view of Reliance Industries Limited (RIL), one of India’s largest and most influential companies in India. He believes the stock price will rise over the next three months due to positive earnings reports and the company’s aggressive expansion plans.

However, Mr Sharma also knows that the market can be unpredictable and wants to protect his investment against a significant downside. He decides to purchase a knock-out barrier option on RIL shares to balance his optimistic outlook with a sense of caution.

He sets the barrier price at Rs. 2,200, slightly below the current price of Rs. 2,300 per share. He pays a premium for this option, which gives him the right, but not the obligation, to buy RIL shares at a predetermined strike price within a specified period.

Here’s how it works: If RIL’s stock price falls to or below the barrier price of Rs. 2,200 at any point during the contract term, the option will automatically deactivate or ‘knock out’. In this case, Mr. Sharma would lose the premium he paid for the option, but his loss would be limited to that amount.

On the other hand, if the stock price remains above the barrier price until the option’s expiration, Mr Sharma has the right to buy the shares at the strike price and sell them at the current market price. This allows him to participate in potential profits from the anticipated price increase.

By using this knock-out barrier option, Mr Sharma tailors his investment strategy to his market view. He can capture potential upside from the expected rise in RIL’s stock price while limiting his downside risk to the premium paid should the stock price fall. This approach provides protection and flexibility that aligns with his investment goals and risk tolerance.

Note: This example is only for illustration purposes and not a recommendation.

Features of Exotic Options

Features of exotic options types include complex payoff structures, dependency on multiple variables, and conditions for activation. These features contribute to the greater flexibility and potential for customisation in investment strategies. Unlike standard options, these options offer a wide range of possibilities for investors to tailor their positions to specific market views or risk management needs.

Recommended Read: Understanding Gold Options

The complex payoff structures of exotic options allow for unique and innovative investment strategies. These options can incorporate various combinations of spot prices, interest rates, volatilities, and other market variables, allowing traders to create intricate risk-reward profiles. By leveraging these complex structures, investors can design strategies that align with their risk appetite and desired outcomes.

Exotic Option vs Traditional Option

Conclusion

Exotic options offer a unique and potentially lucrative opportunity for investors. While they may seem complex and risky, it is important to thoroughly research and understand the terms and conditions of any exotic options before investing.