Exotic Option
Exotic options are a type of financial derivatives that have more complex structures than the usual vanilla options. Originally, they were created as a way to hedge specific risks or to meet certain competitive needs. Exotic options became popular among the local and international institutional investors and were used to gain a competitive edge in the markets.
An exotic option is typically customized and tailored to the specific needs of an investor or a group of investors. This provides them with more flexibility and better risk management than trading in traditional vanilla options. Although exotic options are often more expensive than regular options, they offer much higher payouts, greater hedging opportunities, more flexibility in terms of timing, and more complex strategies.
Exotic options are typically traded on over-the-counter (OTC) markets, which means individual investors cannot directly purchase these options. Instead, they must contract a broker or an online platform to trade these options. Exotic options are also known as derivatives because they are derived from the values of underlying assets, such as currencies, stocks, or commodities. Depending on the structure of each type of exotic option, the payout may depend on a particular type of event or a combination of events in the marketplace.
There are many different types of exotic options, and each type has its own advantages and disadvantages. Some of the most common types include barrier options, digital options, binary options, lookback options, chooser options, and Asian options.
Barrier options allow investors to gain from the potential increase in price of the underlying asset, but only if the price reaches a certain threshold or barrier. If the underlying asset does not reach the specified barrier, then the investor receives nothing.
Digital options provide investors with a fixed payout of a predetermined amount if the underlying asset reaches a predetermined price. They are also known as cash-or-nothing options because they provide a fixed amount of money regardless of the cost of the underlying asset. Binary options are similar to digital options in that they are also all or nothing options, but with binary options the investor can decide whether the asset will be above or below the predetermined price at expiration.
Lookback options allow investors to lock in the maximum or minimum price of the underlying asset at a predetermined time before expiration. Chooser options are useful for investors who are uncertain of the direction of volatility in the market. For these options, investors can select either a call or a put option at expiration. Finally, Asian options provide investors with a payout that depends on the average price of the underlying asset over some period of time prior to expiration.
Overall, exotic options offer investors more flexibility and more opportunities for hedging and gaining from price movements in the markets. However, the downside is that these options are often more expensive than vanilla options and require more sophisticated strategies in order to be profitable. Therefore, investors should consider the types of exotic options available, the potential benefits and costs associated with each one, and their own risk tolerance before they decide to trade these options.
