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  1. Michael C. Thomsett

    Ranges of Exotic Options

    Asian Option has a payoff decided by the average price of the underlying during the option’s life. Also called the Average Value Option, it may be set up with a fixed strike (where averaging is applied rather than the underlying price) or fixed price (in which price replaces the strike). Barrier Options have payoffs determined by whether the underlying reaches or passes a known level during a limited time. They are described as “path dependent” for this reason. They may be knock-out (expires when a known barrier is reached) or knock-in (becomes live when the barrier is reached). They are further defined as four types: up-and-out, down-and-out, up-and-in, or down-and-in. These define (a) whether a call or put is set, and (b) whether the specified level is reached or not by the deadline. Basket Option involves a payoff determined by valuation of a basket of securities rather than on a single underlying. It may be set up based on stocks, commodities, or currencies. Value of this option is the weighted sum, or the weighted average of the assets included. Bermuda Options allows early exercise, but is restricted to only certain dates, at times only one day per month. It may also limit when traders can enter positions. It is a hybrid between American and European style options. Binary Options involve a fixed payoff amount for ITM options, or zero payoff for OTM options. It is also called a digital option or all-or-nothing option. The payoffs are discontinuous, and may be Cash-or-Nothing (zero payoff if price ends up below a call’s strike or above the put’s strike) or Asset-or-Nothing (pays nothing if the underlying is below a call’s strike or above a put’s strike). Boston Options are American style contracts with the premium delayed until expiration date. Canary Option allows exercise style between European and Bermuda positions. The timing is normally set as a quarterly date, but only after a time limit has run, which often is one full year. Capped-Style Option limits the maximum profit possible within the option contract. When the cap amount is reached, exercise takes place automatically. Chooser Options may also be called As You Like It Options. Traders can decide whether it is a call or a put, but only after a period has passed. Cliquet Options are also called strike resets or rachets. It involves a series of positions with special rules for setting up a strike price. It might also involve setting upper and lower limits and a range of strikes. Composite Options are options on one currency, with strikes given in a different currency; also called a Cross Option. Compound Options are options on options in four types. Call on call, call on put, put on call, and put on put. There are two strikes and two exercise dates. Cumulative Parisian Options involve payoff depending on the time the underlying value has remained either above or below the strike. Double Option provides the buyer a combination of call and put and is available primarily in commodities markets. Evergreen Option sets the right to exercise with a notice period. It may involve other terms like exotic options such as the Bermuda Option. This rule gives sellers time to prepare for settlement. Exchange Options allow the holders to exchange one asset for another. It is used for specific types of assets like currencies. Forward Start Options will begin at a specified date in the future. Examples include employee stock options. Game Option is also called an Israeli Option, and gives the writer a chance to cancel, but with a requirement to pay the payoff value plus a fee. Gap options are binary options with a distance between exercise price and strike. The strike identifies the payoff maximum, and the gap identifies whether payoff can be made. Lookback Options have payoffs determined by maximum or minimum underlying price reached during the option’s life. Quanto Options are types of Composite Options where currency exchange rates are fixed before the option is opened. Rainbow Options are opened on several different assets. For example, a short trader may select several outstanding bonds to be underlying securities to a rainbow option. Reoption is a contract that has exercised but allows the owner to repurchase. Shout Option is a European style contract in which the owner can “shout” to the writer and will be paid the greater of the usual payoff or intrinsic value. Standard Parisian Barrier Options set value based on maximum time the underlying has remained above or below a limit price. Swing Option gives buyers the right to exercise one call and one put on known exercise dates, often used in trading of energy futures. The typical exotic option involves rules for moneyness, underlying, and payoff that are far more complex than the more vanilla calls, puts and combinations. Imagine how difficult it might be to set valuation using Black-Scholes or another pricing model, when there are so many variables and timing issues involved in the exotics. Some exotic options may be hedged, even more readily than simple calls or puts. This opens a range of possibilities involving exotic positions, but traders may also discover that the maximum profit or loss is smaller than they expect. This is the unfortunate result of hedging and risk reduction; profitability becomes more limited, not to mention the time allowed for any profits to materialize. Most traders have heard of many of these exotic forms of option, but it should not be surprising for anyone to have not previously heard of all of them. In fact, this list could also be incomplete because many other forms of exotics are likely to exist. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook. Related articles: Lookback Options Ratchet Options Chooser Options Barrier Options Double Barrier Options