Exotic Options Derivatives Overview

Study Notes

Exotic Options Derivatives

Exotic options are a type of options derivative that deviate from standard conventions regarding expiration dates, exercise prices, and payment structures. They offer traders a wider array of strategies and risks compared to traditional options. This article explores four types of exotic options: Asian options, Barrier options, Lookback options, and Binary options.

Asian Options

Asian options are characterized by their payoffs, which are based on the average price of the underlying asset rather than its final price. There are two types of Asian options: Average Price Asian options and Arithmetic Average Price Asian options. The payout of an Average Price Asian option is calculated by taking the arithmetic mean of the underlying asset's price throughout the life of the option. The Arithmetic Average Price Asian option calculates the payout by taking the geometric mean of the underlying asset's price throughout the life of the option. Both types require determining the average price at expiration, which is derived from the closing prices of the underlying asset during the life of the option.

Barrier Options

Barrier options are activated only if the price of the underlying asset breaches a predefined threshold (barrier) during the life of the option. They come in two varieties: up-and-in and down-and-in options. In up-and-in options, the barrier serves as a trigger for activation once crossed, and the option remains active until expiration. Down-and-in options function similarly, except they are triggered when the barrier is breached in a downward direction. For instance, an up-and-in call would result in a guaranteed payoff if the underlying asset's price rises above the barrier. Once the barrier is reached or exceeded, the option becomes an ordinary European or American option.

Lookback Options

Lookback options grant the holder the right to choose the most advantageous strike price at expiration from the range of strike prices observed throughout the life of the option. Lookback options are classified into two categories: floating strike lookbacks and fixed strike lookbacks. In floating strike lookbacks, the strike price fluctuates along with the underlying asset's price, providing the holder immense flexibility near expiration. Fixed strike lookbacks preserve the initial strike price, offering limited flexibility but minimizing potential volatility exposure.

Binary Options

Binary options are simple and straightforward in nature, providing the holder either a predetermined cash amount or nothing upon expiration, depending on whether an underlying condition is met. The condition typically revolves around the price threshold of the underlying asset at expiration. If the condition is satisfied, the binary option pays out the predetermined cash amount; otherwise, it expires worthlessly.

In summary, exotic options expand the horizons of options trading by offering different ways to define strikes, determine payouts, and manage risks. While they provide increased flexibility and customization possibilities, they also demand more sophisticated methods for pricing and understanding their intricacies.

Description

Explore the characteristics and types of exotic options derivatives including Asian options, Barrier options, Lookback options, and Binary options. Learn how these options deviate from traditional conventions and provide traders with a wider range of strategies and risks.