The Traditional Options trading dates back to the ancient times when the very first reputed option purchaser was the ancient Greek mathematician Thales of Miletus. The use of options came into being when Thales predicted a particular season’s olive harvest to be more than usual. When the spring arrived, the olive harvest was actually much more than usual and he exercised his option by renting the olive presses at a much higher price than what he paid for the option.
Well, to give you a general overview of the Traditional Options (also known as Vanilla Options) contract, it gives the holder the right to either buy or sell the underlying asset (investment in assets can vary) at a predetermined price beforehand or on the date of expiration.
The right to buy is known as the call option, whereas the right to sell is the put option. Although the right to buy or sell (trade) exists, the obligation does not! These were the investment styles of Vanilla Options. Ahead we will also see the types of Vanilla Options versus the types of Exotic Options.
Okay! Let us get started with the Exotic Options!
It is a well-known phrase that Exotic Options are “untraditional, experimental and also quite strange”. At the same time, they are interesting and can fetch some gainful results over and above Traditional Options.
However, we will discuss the pros and cons of investing in this interesting instrument later. Exotic Options (like Vanilla Options) also derive their value from underlying assets. These underlying assets can be Bonds, Equities, Futures, Index, Commodities, or Currencies.
Further, let us find out more about Exotic Options, as this article covers:
- What are Exotic Options?
- Vanilla Options versus Exotic Options
- How to Price the Exotic Options With Python?
- What Makes Trading With Exotic Options So Interesting?
- Pros & Cons of Exotic Options
Exotic Options belong to that category of Options Trading or Options Contracts, which are a bit different from the traditional Vanilla Options. These differences are with regard to the payment structures, expiration dates and strike prices.
Also, Exotic Options provide various investment alternatives. This leads to a broader portfolio for the investors.
There are some of the features that explain Exotic Options very well, and these are:
- An Exotic Option has a “payoff” structure which is unlike the traditional Option’s payoff structure. Option payoff is nothing but the net profit/loss made by the buyers and sellers of options.
In case of Exotic Options, the payoff at the maturity is based on not only the value the underlying index holds at maturity but also on its value several times during the course of the contract's life.
- Also, another interesting feature of Exotic Options is that they may also include a non-standard underlying asset/instrument specifically developed for a client in particular or a specific market.
- The value of an underlying asset or instrument can be based on more than one index.
- They are generally traded Over-The-Counter (OTC). Generally, investors choose Exotic Options for getting a diversified portfolio which is quite broad.
- There could be call-ability and put-ability rights.
- Also, it could involve foreign exchange rates in various ways. We will discuss the Exotic Forex Options ahead.
As they are advanced, they surely also have some uncommon advantages. Exotic Options have gained an upper hand over the traditional Vanilla options by:
- Customizing risk-management needs of the investors.
- Providing investors with a broad portfolio to meet their portfolio needs.
- Offering lower premiums as compared to the Traditional Options.
This was it about what Exotic Options are. Now let us move ahead and find out the different types of Vanilla and Exotic Options followed by a comparison between both.
We have already learnt so far as to what Vanilla Options and advanced Exotic Options are. Going further, each of these Options holds a significant difference with regard to their function which can be understood the best by going through the types of each.
Vanilla Options and Exotic Options are divided as explained below.
Vanilla or Traditional Options are divided into two broad categories namely American and European styles or types.
American options allow the holder of the option to exercise the rights associated with it any time before or on the expiration date.
Whereas, having less flexibility, European options are the opposite and do not allow the holder to exercise its rights before the expiration date. It is only on the expiration date of contracts that a holder has the right to trade according to its rights.
Exotic Options are nothing but the hybrid or advanced versions of both American and European Options and keep falling between both. Let us discuss the most common types of Exotic Options one by one.
These options are quite similar in nature with traditional Vanilla calls and puts. The only difference is that they get triggered when the underlying asset or instrument reaches the predetermined price. These are commonly traded in foreign exchange as well as equity markets.
For instance, let us assume a Barrier Option has a Knock-out price set at $110, a Strike price of $100 and currently the Stock is available at $90 for trading in the market. This is in case you are exercising selling rights with puts. Until and unless the price of the underlying asset or the Stock remains below $109.99, the Option will behave like a standard Option. But, as soon as the underlying Stock price will hit $110, the Option will be knocked-out. Knocking out of the Option simply means that it becomes worthless.
On the contrary, Knock-in is when you are exercising purchasing rights (calls). In this case, if the underlying Stock price is below $109.99, the Option will become worthless and it will not exist. Hence, it will only exist if the Stock price hits $110.
The risks with Knocking-in and Knocking-out may not sound nice, but you can exercise an Exotic Option at a lower premium (cost of investing in Option) as compared with traditional Option. Types of Barrier Options are:
- Up-and-Out - Price of the underlying asset or Stock goes up and Knocks-out the Option.
- Down-and-Out - The Price goes down and Knocks-out the Option.
- Up-and-In - Price goes to the specific level and Option gets initiated.
- Down-and-In - Price falls down to the required level and Option gets Knocked-in.
These Option contracts provide the investors with a fixed payout amount in case the price movement occurs. These follow “an all-or-nothing” payout structure.
In the case of Traditional Vanilla Options, the final payouts rise with the rise in the price of the underlying asset price beyond the strike price.
Whereas, in Binary Options, the holder of a binary call option gets a finite lump-sum in case the underlying asset is above the strike price. Also, the holder of a binary put option is paid the finite lump-sum amount in case the price of the asset closes below the strike price.
For instance, if the trader holds the binary call option and has a predetermined payout of $20 at the strike price of $70, then when the stock price will go above the strike price on the expiration date, the holder will get a lump-sum amount of $20. This will be regardless of howsoever high the stock price may reach. Conversely, in case the stock price is below the strike price on expiration, the holder will receive nothing and the loss will be that of the premium.
With binary options, investors can also trade foreign currencies or commodities like crude oil.
These options take into account the average of the underlying asset’s price to find out if there is a profit comparable to the strike price. In this case, for instance, if the Asian call option takes a price average of 35 days, and the average price is less than strike price on the expiration date, the option will expire worthlessly.
This is different from plain vanilla options like European and American options, where option payoff depends on the price of the underlying instrument at the time of exercise.
Asian option payoff can be calculated in two ways:
Average Price Options: The payoff at maturity is equal to the average price of the underlying asset over a specified time period minus the fixed Strike price of the Option.
Average Strike Options: The payoff is equal to the price of the underlying asset at maturity minus a variable strike, which is equal to the average price of the underlying asset over a specified time period.
These options bear the power to give the holder of this option a right (but not an obligation) to exercise the rights and buy any other option, but, at a specific price on a specific date. Since the traditional call or put option has the underlying asset as the equity security, the Compound Option is different. The Compound Option has the underlying asset as another option.
The four types of Compound Options are:
- Call on Call - Provides the right to buy a call option.
- Call on Put - Provides the right to buy a put option.
- Put on Put - Provides the right to sell a call option.
- Put on Call - Provides the right to sell a put option.
These Options are popularly used in foreign exchange as well as the fixed-income markets.
Let us move forward and see how to Price the Exotic Options with Python.
Now, we will see how to use Python to price Exotic Options. We will make use of Monte Carlo Simulation for the same.
Monte Carlo Simulation is helpful here since it is a well-known method of pricing options. According to this model, the value of an option depends on the expected value of the price of the underlying asset on the expiration date. However, price is a random variable and one of the most effective ways of finding the expected value of price is Simulation.
You can read more on Monte Carlo Simulation here.
To apply this model with Python, first of all let us find out the returns on the basis of information like number of days to expiry, the number of simulation runs, Spot Price, Strike, Barrier Option, and Volatility. We will create N paths of returns on an everyday basis.
Running the code above gives us the generated values, that is, 100000 simulation runs in 252 days. Now, we will plot the possible Price Paths using “matplotlib” in the next code and use the “normal random distribution” for plotting the data.
With the help of Monte Carlo Simulation Model, we will get various probabilities of the stock price in the number of days mentioned above.
Running the code above gives us several possibilities of the prices of Option. Although it has a fat tail, a normal distribution is still widely used.
Let us see the histogram of the same data.
The histogram above shows the non-normal distribution of the prices or the Probabilities of Price of the stock.
Moving forward, let us also find out the price of Vanilla call option using Monte Carlo Simulation.
Here, let us take the example with the following situation:
If the Final Price goes less than the Strike Price, Option will become worthless.
In other words, Final Price <= Strike Price -> Worthless Option.
So, we need Final Price > Strike Price
For this, we can use the following code
Running the code above gives us a mean or an average of the price of Vanilla call option. We can base our trading decisions based on this price level.
Perfect! Ahead we will be discussing What Makes Trading With Exotic Options So Interesting?
There are a few reasons why an Exotic Option is an interesting and reliable approach.
These reasons are:
- Hedging & Low Premium Cost
- Interesting types of Options
- Exotic Forex Options
Hedging & Low Premium Cost
Mainly they are used for Hedging, due to Lower Cost of Premium (Cost of buying Options) and Risk Management.
Exotic Option is a type which is best suited for those firms/companies that require Hedging up to or down to the specific price levels of the underlying asset/instrument. An instance can be the Barrier Option as a hedging tool since they enter any investor’s portfolio and even exit the same at a specific price level.
Also, the lesser cost of Exotic Option is due to the reason that an Exotic Option can expire worthlessly above a particular price.
Interesting types of Options
Apart from all this, there are many other types of Options also which make Exotic Options an interesting choice. These types are:
- Double Trigger
Bermuda Options are a combination of American and European options that we discussed above. They are quite similar to European Options though and can be exercised on the preset dates or the date of expiration. Also, you will find that Bermuda is a cheaper alternative than American Options.
Lookback Options are the ones which look back over the life of the underlying asset’s price movements and then determine the payoff on the date of expiration or maturity. They initially do not have a specific price. However, on the date of expiration, the holder has the right to select the favorable strike price out of the many prices that occurred during the lifespan of the Option.
A Double Trigger Option is named so because it requires two conditions for the payoff to be activated. These two conditions can be independent or dependent events in the lifespan of the underlying asset. Also, the conditions alter the risk factor associated with investment in the Option.
The Lock-Out Option decides the payoff based on the underlying asset’s price movement. It pays off if the asset or instrument’s price value does not move beyond a certain or specific price level. Another type is a Double lock-out option which pays off only in case the asset remains within a range of specific values.
These Options decide their value on the basis of several underlying assets or instruments. The payoff of this Option is basically a weighted average of all the underlying assets or instruments involved. Although, another essential point is that the weight of these assets need not always be equal.
Rainbow Exotic Option is mainly available to the institutional investors. They are usually available in multiple variables and also have several underlying assets or instruments. These Options are quite structured and only get activated when a specific number of parameters are fulfilled.
A weather Exotic Option pays off when a predetermined weather condition is met. Hence, as it is based on weather, it is best utilised by those businesses which depend on weather conditions. Such businesses are able to hedge their cash flows to insure themselves against bad weather conditions.
Ok! After the interesting types of Options, we will discuss another wonderful aspect of Exotic Options which makes it interesting, and it is the availability of Exotic Forex Options.
Exotic Forex Options
Exotic Forex Options are a decent way to hedge FX exposures. Although, there are some implied risks and they need to be managed well.
Well, to manage the risk one needs to be sure of the premium cost the Options contract will lead to. You must enter the contract only if your analysis justifies the risk of hedging in another country’s currency.
For instance, let us assume that there are two parties involved in the trade of some goods. First is the British entity and another is an American entity. The former is a seller (or exporter) and the latter is the buyer (or importer) of the goods.
Now, since the British entity is exporting, it is anticipating a payment of, let us say, $100,000 in three months. But, the British entity wishes to secure itself from an adverse event such as devaluation of the U.S dollar against the British pound.
Simultaneously, it also wishes to secure itself from favorable exchange rate movements (movement of currency valuation in opposite direction). You can also refer the article about Real Effective Exchange Rate (REER).
Hence, it buys a European GBP-USD call option at-the-money, which simply implies that the spot price is equal to strike price. Since these options involve premium costs, the British company will have to be sure about the same before investing. It should not go ahead with it in case possible gains are lesser as compared to the risk taken in terms of investing in the option or hedging the USD position.
Alright! We will go forward and discuss the Pros and Cons of Exotic Options.
Exotic options have unique underlying conditions that make them a good fit for high-level active portfolio management and situation-specific solutions. Complex pricing of these derivatives may give rise to arbitrage, which can provide great opportunity to sophisticated quantitative investors. There are many varieties of exotic options, too numerous to describe here, but if you know how to use them, you can learn to profit from nearly any trading scenario.
Exotic Options are the ones with the most unique underlying conditions. All of the unique features of these Options make them the best choice for high-level portfolio management. Also, they provide the best offer for several situation-specific conditions. Let us find out what all benefits and disadvantages one may face with them. By being aware about them both, you can always keep a lookout for minimising the adverse scenarios and maximising your gains.
Pros of Exotic Options
- They usually have lower premium costs as compared with more-flexible American Options (one of the types of Vanilla options).
- They are customizable and can be moulded in accordance with the risk tolerance and gains of the investor.
- One can hedge the funds with them and maintain a broad portfolio.
- Since they are innumerable, they provide solutions to the situation-specific conditions.
Cons of Exotic Options
- An increased cost of premium is there in some of the Exotic Options.
- Even with a low premium cost, there are higher risks of them becoming worthless beyond a price level. For instance Barrier Option.
- They may or may not maximise your gains.
- The reaction of the price movements to that of the market’s events may be different than the Vanilla Options.
In this article, we discussed various unusual aspects of this side of Options which is known as Exotic Options. This content was intended to make you familiar with most of the concepts that revolve around Exotic Options. As some concepts were discussed in brief, with some others we went into the details. We created some interesting Pricing plots for basing your trading decisions on with the help of Python and Monte Carlo Simulation. We also discussed the pros and cons of investing in Exotic Options so that you can refer to them both and find out if the cost justifies your gains. Hope the article helped you gain a significant insight into the world of Exotic Options!
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