What is an Exotic Option? | Definition and Example

An exotic option is a derivative contract that differs from standard options such as American or European options in terms of its expiration date, exercise price, underlying assets, and payoffs. These options typically feature more complex structures and require sophisticated valuation methods.

Exotic option in a nutshell

  • Exotic options differ from standard ones in expiration, payoffs, and underlying assets.
  • They were defined in 1990 by Mark Rubenstein as hybrid securities.
  • Exotic options offer advanced features for risk management and profit potential.
  • Common types include Asian, barrier, basket, Bermuda, and binary options.
  • Exotic options are primarily utilized by institutional investors and experienced traders.

Understanding Exotic Options

Exotic options, defined in 1990 by Mark Rubenstein, a professor at the University of California Berkeley, are hybrid securities characterized by their unconventional payment structures, expiration dates and strike prices. In contrast to traditional options, they command a premium due to their customizability. These options cover a wide range of assets beyond traditional securities, including commodities such as oil, corn and natural gas.

The exotic options come with advanced and complex features. Their features make the investor capable of earning more profits. Furthermore, these features make them ideal financial instruments for risk management and hedging. These options are the result of financial engineering. It aims at creating and bringing new securities into the market. They also focus on developing new and adept pricing techniques. Exotic options are usually traded on the over-the-counter (OTC) market in order to meet the specific requirements of investors. Unlike major exchanges such as the New York Stock Exchange (NYSE), the OTC marketplace operates as a network of traders and brokers.

9 Types of exotic options

Some common exotic option examples include:

Asian options

You can commonly find Asian options as the most common exotic options in the market. The payoff of these options depends on the underlying asset’s average price. This price may vary from time to time depending upon the circumstances in the international market. 

Barrier options

The exotic options that activate when it witnesses a predetermined price are known as barrier options. 

Basket options

These exotic options are available for many underlying assets. The basket option has a payoff based on the underlying assets’ weight average. An investor should note that the underlying asset’s price does not always remain the same. 

Bermuda options

Bermuda options are exotic and a combination of American and European options. However, these are much similar to the European options. An investor can exercise them only when they expire. You can also exercise the Bermuda options at a predetermined date between purchase and expiration dates. 

Binary Options

Binary options are the most traded exotic options in the world at this moment. These options require the trader to choose a yes or no proposition. A trader either predicts accurately or loses his money based on this proposition. Read this article if you want to learn more about the definition and examples of Binary Options.

Chooser options

These exotic options let the holder decide whether an option is a put or call. However, they can decide this only at a fixed date. It is usually before the contract expires.

Compound options

As the name suggests, compound options are those that compound. They are options on options, and the final payoff usually depends on another option. Thus, they come with two strike prices and dual expiration dates. There are four types of compound options:

  • Call on call
  • Call on put
  • Put on put
  • Put on call

Extendible options

Extendible options contracts are those extended options whose expiry dates can get postponed. A purchaser can extend the options when they do not have sufficient money. 

Lookback options

The lookback options are those that do not have a specific price. The holder of these exotic options can select the most favorable strike. 

Exotic options are one of the most profitable trading assets in the market. You can get purchase these contracts and reap the rewards of investment. 

Exotic Options vs Binary Options

Exotic options combine elements of American and European options and offer a wide range of features. In contrast, binary options represent a straightforward all-or-nothing scenario based on a predetermined outcome. Let’s break down the key differences between these two types of options:

FeatureExotic OptionsBinary Options
Payout StructureVariable, based on complex criteria and market conditions.Fixed, providing a predetermined payout upon meeting criteria.
FlexibilityHighly customizable, offering a range of contract terms.Limited flexibility with standard, predetermined terms.
Underlying AssetsIt can be based on various assets, including stocks, commodities, or indices.Mainly limited to equities, currencies and commodities.
Exercise RightsMay include early exercise options depending on the contract terms.Typically, exercise is only at expiration, lacking early exercise opportunities.
Market AccessibilityPrimarily utilized by institutional investors and experienced traders.Accessible to a broader range of investors, including retail traders.

About the author

Percival Knight
Percival Knight is an experienced Binary Options trader for more than ten years. Mainly, he trades 60-second trades at a very high hit rate. My favorite strategies is by using candlesticks and fake-breakouts

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