Another Look at Trading Exotic Options

In the first part of this article, the difference between plain vanilla and exotic options was briefly explained. The primary exotic option, the Barrier option was also touched upon. This section will define and explain several more exotic option types that you may run across in your trading and market studies.

Where will the average trader experience exotics?

Most retail traders will experience exotics in the Forex marketplace. Several Forex Dealers offer various exotics to their retail clients. However, they are generally the domain of institutions and large, well-capitalized traders in other markets.

Investors sometimes are exposed to exotic options in so-called "structured products" that have exotics embedded in them. There are literally dozens of exotic option types with more being created all the time for specific purposes. Remember, exotics are between the trader and the broker, not traded on an exchange. Therefore, almost anything that can be imagined and mutually agreed upon on the institutional or large trader level can be turned into an exotic option.

The following are a few of the more common exotics:

The Look Back Option - This option, on the surface, appears to be every option trader's dream. It allows you to look back over the term of the underlying instrument, at expiration, and choose the most favorable time to exercise the option. They are considered to be path reliant, meaning the payoff is based on the maximum or minimum price during the period.

There are two primary types, fixed and floating.

Fixed means the strike price is set prior to purchase. A fixed look back option is exercised based on the best possible underlying instrument worth during the term of the option. For example, calls would be exercised at the highest worth and puts at the lowest worth during the term of the option.

Floating means that the strike price is set at expiration. A call's strike is fixed at the lowest price, and a put's strike at the highest price of the underlying instrument.

As you can imagine, look backs can be very expensive and become rather complex when calculating due to all the variables involved.

Asian Option - These are also known as "Average Options". The payoff is not linked to a specific strike price but rather the average price of the underlying during the options lifespan. Some books teach that this option form was developed in Asia to prevent option traders from attempting to manipulate the price on expiration. However, other sources report that the name came from the creation in 1987 of this style in Asia for Crude Oil trading.

Bermuda Option - Bermuda options are options that are midway between American exercise and European exercise. They can be exercised on a few specific dates prior to expiration. Whereas, American options can be exercised at any point during the lifespan of the option; European options can only be exercised at expiration.

Digital Option - This is likely the most common exotic option for the average retail trader. They are also called binary options. Think about digital or binary code for an easy way to remember the definition. Zero or one, yes or no, win or lose are all ways to visualize a Digital option. The payout is fixed after a predetermined strike is hit and doesn't change. All or nothing is another term you will hear to describe Digitals. These are extremely common in the Forex market, with several brokers offering them along with pricing calculators on the trading platform.

This is a very brief overview of several exotic option types. Exotics can get very complicated but every trader at least needs to have a rudimentary understanding of Exotics.

David Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.