Exotic Options

Exotic options are financial instruments that have more unique features than traditional vanilla options.

Exotic options cover a variety of different instruments and have structures and triggers that relate to the option’s payoff.

Many exotic options are designed for traditional markets, such as:

But some may be constructed for a particular non-traditional market.

For example, exotic options have been designed to bet on:

  • weather
  • election outcomes
  • electricity markets
  • natural resource deposits
  • whether a business bid is accepted or not
  • inflation
  • freight deliveries
  • values of properties and real estate assets

These aren’t directly available within traditional financial assets. Some exotic options are designed to target a certain financial market variable more specifically, such as volatility.

Some may be designed by a bank or investment manager to help a client offset a particular type of risk.

These options are generally traded over the counter (OTC) or hosted on specialty platforms.

Asian Options

Asian options are considered a form of exotic option.

The payoff is based on the average underlying price over some predetermined timeframe. (They were first developed for the average price of oil in 1987.)

This differs from traditional American and European options, which have payoffs determined by the price at the time they’re exercised.

Features Of Exotic Options

An American or European option, that is a straight call or put, is considered a vanilla option.

Exotic options normally have two main types:

– path-dependent

– path-independent

Path-dependent options depend on not only the final price leading up to expiration, but also the prices over the duration of the contract that led up to the final price.

Path-independent options only depend on the final price of the underlying.

Other Features

– Settlement in the form of cash or ownership of the underlying.

– Could be dependent on more than one underlying price (e.g., multiple indexes).

– The payoff could depend on the average price over time, maximum or minimum prices, a one-touch or range option, spread options, and so on. (Different types of exotic options will be covered below.)

– There could be foreign exchange rates involved in the payoff.

Quasi-Exotic Securities/Options

Convertible bonds are valued based on not only the price of the underlying stock price but also its volatility, the level of a risk-free rate (e.g., short-term interest rates), and the credit rating of the company.

Barriers In Exotic Options

Barriers in exotic options involve some type of price level of the underlying that may influence the payoff.

Touch options will involve triggering a payoff if one or more price barriers are touched.

Range options, which can be a form of touch options, may trigger a payout if one of the barriers is touched within a given timeframe.

For example, a range option may involve the 1.20-1.22 area on the EUR/USD.

 

 

One bet could be that the price moves outside of that range within a given timeframe, perhaps due to higher expected volatility. Another bet could involve betting that price will remain within that range within the given timeframe, effectively a bet on low volatility and/or neutrality on market direction.

These can be one-touch options in nature. Namely, if price hits a barrier at any given point the payoff is triggered and the option is closed.

They can also be boundary related options that expire at a certain date and time. Instead of triggering on a breach of the level, it’s about where price is at expiration that determines the payoff.

Other Types Of Exotic Options

Binary Options

Binary options involve a payoff that is a fixed amount or nothing.

There are cash-or-nothing binary options, which provide some fixed amount of money if the option expires in-the-money (ITM). There are also asset-or-nothing binary options, which provide the value of the underlying asset if ITM.

Binary options are often called by other terms, including:

  • digital options (particularly in the FX or interest rate markets)
  • all-or-nothing options, or
  • fixed return options (FROs)

Spread Options

Spread options bet on the spread between two different instruments.

For example, the crack spread is the difference in price between refined products – gasoline and heating oil – and the price of the unrefined commodity (crude oil).

If the crack spread increases, this is interpreted as refining margins increasing, due to supply/demand dynamics or weaker crude oil prices.

Instead of buying gasoline and heating oil and shorting crude oil, the trader might simply buy a call option on the crack spread.

Similarly, if the crack spread is anticipated to decrease, the trader might buy a put option on the crack spread.

Spread options are common in commodity markets. Crush spreads involve the difference in prices in raw and refined product in the soybean markets. Spark spreads refer to the electricity markets (price received by a generator and cost of the natural gas used to produce that electricity).

They are also available in interest rate and currency markets.

Basket Options

A basket option is a type of exotic option whose underlying is a weighted average of different assets that have been grouped together as part of a basket.

It is similar to an index option, providing a number of stocks that have been grouped together in an index, which represents the option’s underlying.

Indexes are essentially a weighted average of various underlying assets. Basket options are normally written on a basket of equity indexes. However, they can also be written on a basket of individual stocks.

It could be grouped as a specific selection of stocks, or could represent a trader’s equity portfolio.

For example, if an institutional trader owns 100 different stocks, instead of having to hedge each position individually and face the difficult task of tracking them in real-time and racking up lots of transaction costs, a basket option could be tailored to fit the specific portfolio.

Lookback Options

A lookback option, sometimes called a hindsight option, is a type of exotic option that enables the owner to buy or sell the underlying at the maximum or minimum price over the life of the option, depending on the type.

A lookback option effectively has path dependency because of the notion that the trader can “look back” over the course of the option’s life to determine the payoff.

The upside of a lookback option is that it reduces the potential that the option will expire worthless. This is favorable for the buyer who will effectively pay in some way for that benefit.

Outperformance Options

Outperformance options involve a payoff determined based on the relative performance of one asset in relation to another.

For example, it could involve betting on the performance of the S&P 500 relative to the NASDAQ, or the Dow Jones (large caps) in relation to the Russell 2000 (small caps).

Or it could bet on the price of WTI crude oil relative to the price of Brent crude oil.

Outperformance options are similar to spread options. They are normally European-style and settled in cash (rather than potentially conveying ownership of the underlying).

Himalaya Options

A Himalaya option is a type of “mountain range option” where there are multiple payout dates and multiple assets within the underlying index being measured.

On each payout date, the option pays based on what asset performed best in the basket of the underlying.

The asset is then taken out of the basket and another payout cycle begins.

Quanto Options

Quantity-adjusting options, also known as Quanto options, are a type of cross-currency derivative settled in cash.

The underlying asset is denominated in a currency other than the currency in which the option is settled.

For example, the Nikkei 225 is denominated in Japanese yen, but a Quanto option could settle the contract in USD, EUR, GBP, or another currency.

Similarly, the S&P 500 is priced in USD, but a Quanto option could settle the contract in EUR, JPY, and so on.

As a result, these options are commonly called guaranteed exchange rate options.

Quanto options come in the form of both calls and puts and are fundamentally used to help traders hedge their currency risk.

If a US trader puts money in a foreign stock index or any type of asset denominated in foreign currency, they expose themselves to not only the changes in the asset price itself but also fluctuations in the exchange rate between the currencies.

Interest Rate Option

An interest rate option is a derivative contract based on an underlying interest rate, such as the fed funds rate or SOFR.

Some traders will also use the bond futures markets to bet on interest rates, such as 2-year, 5-year, 10-year, and 30-year futures (ZT, ZF, ZN, and ZB, respectively).

Swaptions

Swaptions convey the ability for traders to enter into an interest rate swap (i.e., an option on a swap contract).

Swaptions can be used to make outright bets on interest rates or can be used by traders or corporations to help hedge certain types of interest rate risk or types of liabilities (e.g., floating-rate liabilities, fixed-rate liabilities).

Bermuda Options

Bermuda options are a type of derivative that can be exercised only on specific dates at predetermined prices. This often entails the ability to exercise just once per month. For options of this nature, it is commonly the first business day of the month.

Bermuda options typically come with the advantage that they are cheaper than traditional American options. However, the trade-off is, of course, the ability to only exercise during certain days of the calendar.

Bermuda Option Example

Suppose a trader owns stock in Coca-Cola (KO). The trader bought shares at $50 per share and wants to insure against a drop in the company’s share price.

In this case, a Bermuda-style put option could be a lower-cost option to a traditional American vanilla put option.

Let’s say the Bermuda-style option expires in twelve months, with a strike price of $45 (i.e., the trader doesn’t want to lose any more than 10 percent of his principal).

The option costs $2.50, or $250 each given each option contract contains 100 shares. This protects against a decline below $45 for the next twelve months.

The Bermuda feature of the option enables the trader to exercise early on the first business day of each month beginning in, for example, the third month.

If the stock price falls to $40, by the first business day of the option’s third month, the trader decides to exercise the put option.

The stock is sold at $40 while the strike price of $45 provides a profit of $2.50 per share (the $5 per share it was ITM minus the cost of the option).

Since the trader also lost $10 per share overall from the stock declining from $50 to $40, but recovered $5 from the option and paid $2.50 per share in premium, the net loss is $7.50 plus any additional commissions.

This compares to a standard loss of $10 per share without the option.

If the stock price increased after the option was exercised but before the option’s expiry, the trader would not be able to take advantage of those gains.

Bermuda options provide flexibility on when to exercise, but it of course might not be the best choice.

Forward Start Options

A forward start option is a type of derivative where a premium is paid for an option that is not yet active, but will become active at some point in the future. The expiration is established once entering into the contract.

The price of the asset is not known at the outset.

Accordingly, it is typically structured such that the strike price will be set in the future so that the option is either at-the-money, or in-the-money, or out-of-the-money by a certain amount at the beginning.

Stock options given to company executives, founders, and/or certain outside investors are a type of forward start option.

Cliquet Options

A cliquet option, also known as a rachet option, is a series of forward start options. The first option is active right away. Once it expires, the second becomes active, and so on.

Each option has an at-the-money (ATM) strike price when it becomes active.

Cliquet options can be thought of as a bundle of ATM options but with the total premium being known ahead of time.

Payout can be at the end of each reset period or it can be paid at the final maturity of the option.

Rainbow Options

A rainbow option has two or more underlying factors that impact its price.

Rainbow options are similar to basket options. The main difference is that instead of paying out on a weighted average (like an index), a rainbow option will typically just pay based on the outcome of one of them as stipulated by the contract.

For example, this could mean the largest in-the-money (ITM) position of various different assets included, such as a basket of stock indices.

If a rainbow option includes the S&P 500, NASDAQ, Dow Jones Industrial Average, and the Russell 2000, it could payout based on whatever index provided the highest return. Or it may payout based on a weighted average of the return of each or however it was packaged.

Chooser Options

A chooser option is a special type of exotic option that enables the purchaser a period of time to determine whether it will be a European call or put option.

For example, a six-month chooser option on the S&P 500 might give the purchaser one month to decide whether it will be a call option or put option.

A trader might want a chooser option when an upcoming event may determine an asset’s future direction.

It is analogous to the idea of a straddle with respect to vanilla option strategy. A trader that is long a straddle is making a type of bet on volatility.

After the expected event occurs that steers price in a particular direction, the trader may opt to drop one leg of the trade (e.g., the profitable leg) and choose to effectively turn the position into a call or put position.

Compound Options

A compound option is an “option of option” in that it involves the value of a separate option.

A compound option, accordingly, can have two different strike prices and two different expiration dates.

Compound options are not common in equity markets, but can sometimes be seen in currency or bond markets.

Sometimes, due to liquidity risk or a separate risk factor, an option may not adequately protect against certain types of risk.

Because options give convexity – i.e., limited downside but potentially unlimited upside – compound options can provide an additional layer of convexity.

There are four basic types of compound options:

  • Call on Call (CoC)
  • Call on Put (CoP)
  • Put on Put (PoP)
  • Put on Call (PoC)

Commodore Options

Commodore options are a series of barrier options that pay if the level of the underlying is above a certain barrier.

For example, let’s say one hypothetically owned a commodore option on the S&P 500, with a 2 percent barrier threshold, that would provide a 5 percent coupon payment if met.

In other words, in exchange for paying a premium, if the index is 2 percent above the strike, a 5 percent coupon will be paid.

A trader might enter into such an option to limit one’s downside exposure to a volatile stock market. In exchange, the trader forgoes the potential upside.

For the next maturity, the index might need to be 4 percent above the strike price, in exchange for an additional 5 percent coupon (10 percent worth of coupons total).

Likewise, for the next maturity, the index might need to be 6 percent above the strike price to provide an additional 5 percent coupon (15 percent worth of coupons total).

In such an arrangement, a trader could get multiples of the total return of the index at a fixed risk.

The downside is the trader could forgo some gains while paying the option premium and end up receiving nothing if the barriers don’t trigger.

Timer Calls

A timer call enables buyers to specify the level of volatility used to price an option.

Generally, in option pricing, implied volatility is used to price an option. In a timer call, the volatility is held constant and the maturity is left undetermined.

Option sellers are often left exposed to risk associated with big spikes in volatility should realized volatility exceed implied volatility. However, with a timer call, this risk is reduced.

With standard vanilla options, there is an implied premium in call options, as dealers want to price implied volatility above expected realized volatility to make a profit on the arrangement (similar to how an insurance company makes money). With a timer call, the buyer gets to avoid this premium.

If volatility increases, the call terminates early. The call buyer realizes a profit. If volatility doesn’t rise above what’s anticipated, the call will mature at a later date.

Contingent Convertible Bonds (CoCos)

Contingent convertible bonds – also known as CoCos or sometimes enhanced capital notes (ECN) – can be considered a type of exotic option.

CoCos are similar to traditional convertible bonds. Bonds can be converted into equity if a certain strike price is reached. They also carry specific options that can help the financial institutions that issue them absorb a drop in their equity position.

This helps avoid the risk of undercapitalization and potential solvency risks, similar to what occurred in the 2008 financial crisis.

CoCos are fundamentally designed to help reduce the risk of a deterioration in a bank’s balance sheet by enabling them to convert debt to equity if certain conditions occur that make the move amenable.

For banks that are struggling, they do not have to pay interest on the bond, repay principal, or convert the bond to stock. As a result, they are higher-risk but higher-yield securities.

Accordingly, they are a type of bond-equity hybrid investment.

CoCos are common in Europe and Asia, but are not allowed in the United States. Americans banks prefer to issue preferred equity, a tranche of capital between debt and equity.

Variance Swaps

A variance swap enables traders to hedge risks or speculate on an underlying asset, volatility, interest rate, exchange rate, or other variables.

One part of a variance swap will pay the realized variance of the price changes on the underlying instrument.

Variance swaps typically pay log returns of daily price movements.

The other leg of a variance swap will pay a fixed amount, which is quoted when the contract begins.

The payoff will be the difference between the floating and fixed leg and settled in cash upon expiry. Cash payments may also be made over the duration of the swap, depending on the arrangement.

Variance swaps are often preferred to vanilla options because they can purely focus on volatility.

Vanilla options provide access to volatility bets, but if a trader’s interest is purely on volatility, it requires consistent delta hedging. Otherwise, one is also betting on the price direction of the underlying asset.

A trader could also use a series of options and roll it on a consistent basis – to neutralize the influence of the underlying asset’s price – to replicate a variance swap. This is called an options strips strategy.

But overall, these two approaches (e.g., consistent delta hedging or options strips) can be very costly to put on.

Overall, variance swaps avoid the delta (directional price risk) inherent in vanilla options. Profit and loss from a variance swap is therefore more centrally focused on the difference between the realized and implied volatility of the underlying.

Box Spreads / Box Options

A box spread is a relatively rare trade where positions are put on to obtain a riskless payoff.

A box may be constructed by combining a bull spread with a bear spread.

For example:

– Bull spread: Long 90 call, short 100 call

– Bear spread: Long 100 put, short 90 put

The value of the box spread at expiration is $10 (the difference in strike prices) minus the premium.

This assumes that the underlying stock does not go ex-dividend before the options expire.

Take an example of stock X where the prices of 90 and 100 calls and puts are the following:

Long 90 call = $6.40

Short 100 call = $1.20

Short 90 put = $0.70

Long 100 put = $5.20

The cost of the premium is $6.40 – $1.20 – $0.70 + $5.20 = $9.70

Independent of what the share price ends up, the terminal payoff being long the box spread is $10 (100 minus 90).

The total profit is nominally $0.30, or the $10 minus the $9.70 premium.

If there’s a risk-free rate available that the trader could capture, that $0.30 would turn into something lower because of the discounted value. (In other words, instead of putting on the box spread, the trader could have been collecting interest risk-free at some rate.)

The discounted value of the total profit would depend on the duration of the trade.

There are also transaction costs, which end up eating away all of that profit. This includes commissions and option and stock spreads.

Given the multiple legs of the trade, the commissions and total costs can be high.

Moreover, markets tend to close any pockets of price discrepancies where arbitrage opportunities may exist. So, it’s rare for there to be a total risk-free arbitrage profit after accounting for transaction costs. For that reason, the box spread has traditionally been a trade made by market makers only.

The box spread is sometimes known as the alligator spread, given the idea that opening and closing a large number of trades can “eat into” one’s profits.

Box Spreads Are Normally European Options

European options can’t be exercised early, so box spread trades are normally made with these types of options only.

American options come with the risk that they could be exercised early and potentially expose a trader to undesirable risk.

Because of the early exercise risk with American options, some brokers do not allow box spreads to be opened on their platforms.

This includes Robinhood after a WallStreetBets incident left one trader down significantly believing he was executing an arbitrage trade that would provide riskless profit.

The trader failed to realize that options could be exercised early, which exposed the trade to significant risk and subsequent losses.