For a trader that is already familiar with vanilla options, forays into the world of exotic options can be an interesting way to add some pizzazz to your options trading portfolio. Exotic options are also utilized by companies that need very specific options to manage risk. A company who relies heavily on a certain imported commodity can for instance utilize one or several very specific commodity options to handle the risk associated with commodity price fluctuations and forex exchange rate movements.
Below, we will take a closer look at a few of the many available exotic option types. The category ”exotic options” is very broad and heterogeneous, and sometimes several different option types are combined within the same option.
- Basket options
While a vanilla option has one underlying, the basket option has at least three.
You need to check the options contract to see if all three underlyings in a basket option are of equal weight or not.
- Extendable options
Extendable options gives the holder a right, but not any obligation, to extend the lifetime of the option. As the option draws near its original expiration date, there will be a specific period during which the holder can elect to extend the option. Always check the options contract to find out about the specifics before you make any purchase.
- Compound options
A compound option gives the holder a right (but not an obligation) to purchase another specific option at a pre-determined price on or by a specific date. It is thus an option where the underlying is another option.
Compound options are especially common on the foreign exchange option market.
There are four different types of compound options:
- Call option on call option
- Call option on put option
- Put option on put option
- Put option on call option
- Chooser options
With a chooser option, the holder gets to chose if the option is a put option or a call option. This choosing takes place at a certain point during the option´s lifetime.
- Range options
The payoff from a range option depends on the difference between the maximum and minimum price of the underlying asset during the life of the option. All other things equal, a range option tends to cost more to buy than a vanilla option, since the range option removes certain risks associated with the proper timing of entry and exit.
- Spread options
For a spread option, the underlying is not an asset such as a company share or a commodity. Instead, the underlying is the spread (difference) between two underlying assets.
- For this spread option, the underlying is the spread between Company A´s share price and Company Z´s share price on the option´s expiry date. The strike price is 5 USD.
- On the expiry date, Company A is trading at 110 USD and Company B at 98 USD. 110 – 98 – 5 = 7. The spread option is in-the-money and the holder gets paid 7 USD.
- Shout option
The holder of a shout option is allowed to lock in a certain amount of profit without rendering the option useless.
- You buy a shout call option where the underlying is stock in Company EFGH. The strike price is 100 USD. There is 1 month left before the option´s expiry date.
- The share price for Company EFGH has now increased to 120 USD. You decide to lock in the price and have a guaranteed profit of 20 USD.
- On the option´s expiry date, the share price for Company EFGH is 105 USD. But since you locked in the 20 USD earlier, you are paid 20 USD instead of just 5 USD.
An alternative scenario for the third point: On the option´s expiry date, the share price for Company EFGH is 125 USD. You get paid 25 USD. Locking in the profit at 20 USD doesn´t prevent you from earning more than 20 USD from this option; it just prevents you from earning less than 20 USD.