You will sometimes hear about exotic options. What are exotic options? What’s the difference between a regular option and an exotic option? This brief primer is design to explain the basic differences and outline the most common exotic options.
Now, before you read this, you should have a fairly good understanding of regular options. If not, go back and read up on our tutorials covering option basics.
Exotic options and regular options share the concept of having the right to buy or sell an asset in the future, but the way investors realize profits using exotic options can differ dramatically from regular options.
The simple definition of an exotic option is that it is any type of option other than the standard calls and puts found on major exchanges. With regular options, an investor who buys a call option has purchased an industry-standardized right to purchase a specific amount of an underlying asset at the agreed upon strike price. An investor who buys a put option buys the right to sell the specific asset at the strike if the price of the underlying decreases. These regular options are also also known as plain vanilla options.
Exotic options, while retaining much of the basic structure of a plain-vanilla option, can have all kinds of different rules attached to them which can significantly change the nature of the option. It’s probably easiest to look at some examples of some of the most common exotic options:
Asian option: Anyone who invests in regular options will attest to their volatility. Asian options are a good way to reduce this volatility. These exotic options have a payoff that depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. The Asian option is sometimes called an “average option.”
Barrier option: This type of exotic option has a payoff that depends on whether or not the underlying asset has reached or exceeded a predetermined price. The right to purchase the underlying at an agreed strike price only becomes valid when the price hits the agreed upon ‘barrier.’ This is unlike a regular option because the holder of a regular option can buy the underlying security at the strike price at any time after inception.
Chooser option: The chooser option gives the investor the right to choose whether the option is a put or a call at a certain point during the option’s life. Unlike plain-vanilla options that are always purchased as a call or a put at inception, a chooser exotic option can essentially change type during the life of the option.
The final difference between exotic options and regular options is how they trade. Regular options trade with calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange. Exotic options are mainly traded over the counter (OTC), which means they are not listed on a formal exchange, and the terms of the options are generally negotiated by brokers or dealers and are not as standardized as they are with regular options.
For this reason, exotic options are best left to advanced options traders. If you want to get into the game, you’ll most likely have to do it through an options broker.
