Definition of Exotic Option
Exotic options are the non-traditional option strategy. This type of option strategy differs from the normal option strategies. This option strategy is also known as a hybrid option strategy in which the investors can customize the option strategy as per their requirements. These options are not like plain vanilla options, rather these option strategies are a little bit tricky and risker to use. The exotic option also helps the investors to gain substantial returns on the investment.
Exotic options are the option strategy that is different from that the traditional options strategy. The exotic option strategy helps the investors to make an investment plan and they can customize the plan according to their preference. The exotic option is very flexible and is also hybrid in nature but they can be risky at times and can affect the profit percentage of the investor. But the customized feature of this option makes things easier for the investors. These option contracts are easier to find in the market. Option is the combination of both the American option and the European option. The option holder can exercise the option after the expiration date or on the expiration date. The features of both the American and the European options are well combined in this option strategy. It has been seen that option is mostly traded in the OTC (Over Counter) market. The option is a combination of complicated valuation, and therefore experts are required to understand the whole scenario of the market.
Features of Exotic Option
- The exotic options are the hybrid option.
- In option, the investor can enjoy both features of American and European option i.e. the option can be exercised both on the expiration date as well as before the expiration date.
- Option is risky.
- Option can be customized as per the requirements of the investors.
- Option holder can achieve substantial returns from the investment.
- Options are a non-traditional option strategy.
Example of Exotic Option
If an investor wants to invest in an exotic option then
Exotic options trading: Exotic option is available in the OTC market i.e. counter market in which the option is traded like any other option. The exotic option is a combination of some complex valuations which also include the payoff of certain options. The option holder of this option will get various exercising options on or prior to its expiration date. The exotic option is totally different from the normal or plain vanilla options. These options require specific skills and knowledge to make out profits and thus advice from the experts are required to understand the concept of option.
Types of Exotic Option
Following are the types of exotic option are:
- Barrier Option: The barrier option is one of the most popular option strategies. In this type of option strategy, the payoff depends on the prices of the underlying assets. This option works when the predetermined price of this option reaches its level.
- Binary Option: This is a typical option strategy in which the option holder will receive the payoff amount only after the occurrence of a certain event. The investor also calls it an all-or-nothing payoff. It is popularly known as the digital option.
- Bermuda Option: The Bermuda option is a combination of both American and European option. This option can be exercised at the date of expiration. The Bermuda option can be exercised on the date of predetermined dates i.e. between the dates of purchase and the expiration dates.
- Basket Option: These options are completely based on the underlying assets. The weighted average of the underlying assets is found to calculate this.
- Compound Option: The compound option is the option strategy that depends upon the payoff of another option of the underlying asset. Due to this dependency, this option is not much in demand.
- Spread Option: The spread option is that type of option which is found by taking the differences of the two options. These bonds are not very much in use because of the dependency factors involved.
Some of the advantages are given below:
- Options are customized and thus the investor can make their own set of portfolios for investing.
- Option can fetch a good amount of returns from the customers and thus the investors can invest their proceeds.
- Option offers some protection as compared to the other plain vanilla options from the risk.
- Option is not an expensive one and therefore any investor can invest in this option.
- If an investor is keen then he can make a good amount of returns from this option strategy.
- Options also have hedging option and therefore the investor can invest in this option strategy.
Some of the disadvantages are given below:
- The exotic option is very complicated and thus the investors are expected to have a good knowledge of the exotic option before investing.
- The lack of knowledge can lead to some serious loss therefore the risk factor is always there.
- Sometimes it has been seen that option are very hard to buy or sell this is due to the unexpected market condition.
- The pricing of option is also very rare and thus the pricing of option can be different from different calculations.
Option strategy is a unique type of option strategy which contains the risk but the returns for the options are very good if the investors get a correct idea of how to invest in option. The exotic options are very complex and thus the investors should invest their time to understand the market before investing. The exotic options are customized and thus the option holder can have a safe and expected investment because the investors are given the opportunity to modify or customize the option strategy as per their requirement.
This is a guide to Exotic Option. Here we also discuss the definition and features of exotic option along with advantages and disadvantages. You may also have a look at the following articles to learn more –