what is an exotic option 
exotic options are a category of options contracts that differ from traditional options in their payment structures expiration dates and strike prices the underlying asset or security can vary with exotic options allowing for more investment alternatives exotic options are hybrid securities that are often customizable to the needs of the investor understanding exotic optionsexotic options are a variation of the american and european style options the most common options contracts available american options let the holder exercise their rights at any time before or on the expiration date european options have less flexibility only allowing the holder to exercise on the expiration date of the contracts exotic options are hybrids of american and european options and will often fall somewhere in between these other two styles a traditional options contract gives a holder a choice or right to buy or sell the underlying asset at an established price before or on the expiration date these contracts do not obligate the holder to transact the trade the investor has the right to buy the underlying security with a call option while a put option provides them the ability to sell the underlying security the process where an option converts to shares is called exercising and the price at which it converts is the strike price exotic option vs traditional optionan exotic option can vary in terms of how the payoff is determined and when the option can be exercised these options are generally more complex than plain vanilla call and put options exotic options usually trade in the over the counter otc market the otc marketplace is a dealer broker network as opposed to a large exchange such as the new york stock exchange nyse further the underlying asset for an exotic can differ greatly from that of a regular option exotic options can be used in trading commodities such as lumber corn oil and natural gas as well as equities bonds and foreign exchange speculative investors can even bet on the weather or price direction of an asset using a binary option despite their embedded complexities exotic options have certain advantages over traditional options which can include exotic options usually have lower premiums than the more flexible american options exotic options can be customized to meet the risk tolerance and desired profit of the investor exotic options can help offset risk in a portfolio some exotic options can have increased costs given their added features exotic options do not guarantee a profit the reaction of price moves for exotics to market events can be different than traditional options types of exotic optionsas you may imagine there are many types of exotic options available the risk to reward horizon spans everything from highly speculative to more conservative below are several of the most common types you may see chooser options allow an investor to choose whether the option is a put or call during a certain point in the option s life both the strike price and the expiration are usually the same whether it is a put or call chooser options are used by investors when there might be an event such as earnings or a product release that could lead to volatility or price fluctuations in the asset price compound options are options that give the owner the right not obligation to buy another option at a specific price on or by a specific date typically the underlying asset of a traditional call or put option is an equity security however the underlying asset of a compound option is another option compound options come in four types these types of options are commonly used in foreign exchange and fixed income markets barrier options are similar to plain vanilla calls and puts but only become activated or extinguished when the underlying asset hits a preset price level in this sense the value of barrier options jumps up or down in leaps instead of changing price in small increments these options are commonly traded in the foreign exchange and equity markets as an example let s say a barrier option has a knock out price of 100 and a strike price of 90 with the stock currently trading at 80 per share the option will behave like a standard option when the underlying is below 99 99 but once the underlying stock price hits 100 the option gets knocked out and becomes worthless a knock in would be the opposite if the underlying is below 99 99 the option does not exist but once the underlying hits 100 the option comes into existence and is 10 in the money itm barrier options can be used by investors to lower the premium for buying an option for example a knock out feature for a call option might limit the gains on the underlying stock there are four types of barrier options a binary option or digital option pays a fixed amount only if an event or price movement has occurred binary options provide an all or nothing payout structure unlike traditional call options in which final payouts increase incrementally with each rise in the underlying asset price above the strike binaries pay a finite lump sum if the asset is above the strike conversely a buyer of a binary put option is paid the finite lump sum if the asset closes below the stated strike price for example if a trader buys a binary call option with a stated payout of 10 at the strike price of 50 and the stock price is above the strike at expiration the holder will receive a lump sum payout of 10 regardless of how high the price has risen if the stock price is below the strike at expiration the trader is paid nothing and the loss is limited to the upfront premium besides equities investors can use binary options to trade foreign currencies such as the euro eur and the canadian dollar cad or commodities such as crude oil and natural gas binary options can also be based on the outcomes of events such as the level of the consumer price index cpi or the value of the gross domestic product gdp early exercise may not be possible with binaries if the underlying conditions have not been met bermuda options can be exercised at preset dates as well as the expiry date bermuda options might allow an investor to exercise the option only on the first of the month for example bermuda options provide investors with more control over when the option is exercised this added flexibility translates to a higher premium as compared to european style options which can only be exercised on their expiration dates however bermuda options are a cheaper alternative than american style options which allow exercising at any time quantity adjusting options called quanto options for short expose the buyer to foreign assets but provide the safety of a fixed exchange rate in the buyer s home currency this option is great for an investor looking to gain exposure in foreign markets but who may be worried about how exchange rates will trade when it comes time to settle the option for example a french investor looking at brazil may find a favorable economic situation on the horizon and decide to put some portion of allocated capital in the bovespa index which is the largest stock exchange in brazil however the investor is concerned about how the exchange rate for the euro and brazilian real brl might trade in the interim typically the investor would need to convert euros to brazilian real to invest in the bovespa also withdrawing the investment from brazil would require converting back to euros as a result any gain in the index might be wiped out should the exchange rate move adversely the investor could purchase a quantity adjusting call option on the bovespa denominated in euros this solution provides the investor with exposure to the bovespa and lets the payout remain denominated in euros as a two in one package this option will inherently demand an additional premium that is above and beyond what a traditional call option would require look back options do not have a fixed exercise price at the beginning instead the strike price resets to the best price of the underlying asset as it changes the holder of a look back option can choose the most favorable exercise price retrospectively for the period of the option look backs eliminate the risk associated with timing market entry and are typically more expensive than plain vanilla options for example say an investor buys a one month look back call option on a stock at the beginning of the month the exercise price is decided at maturity by taking the lowest price achieved during the life of the option if the underlying is at 106 at expiration and the lowest price during the life of the option was 71 the payoff is 35 106 71 35 the risk to look backs is when an investor pays the more expensive premium than a traditional option and the stock price does not move enough to generate a profit asian options take the average price of the underlying asset to determine if there is a profit as compared to the strike price for example an asian call option might take the average price for 30 days if the average is less than the strike price at expiration the option expires worthless basket options are similar to plain vanilla options except that they are based on more than one underlying for example an option that pays out based on the price movement of not one but three underlying assets is a type of basket option the underlying assets can have equal weights in the basket or different weights based on the characteristics of the option a drawback to basket options can be that the price of the option might not correlate or trade in the same manner as the individual components would to price fluctuations or the time remaining until expiration extendible options allow the investor to extend the expiration date of the option as the option reaches its expiration date extendable options have a specific period that the option can be extended the feature is available for both buyers or sellers of extendable options and can be helpful if the option is not yet profitable or out of the money otm at its expiry the underlying asset for spread options is the spread or difference between the prices of two underlying assets as an example say a one month spread call option has a strike price of 3 and utilizes the price difference between stocks abc and xyz as the underlying at expiry if stocks abc and xyz are trading at 106 and 98 respectively the option will pay 5 106 98 3 5 a shout option allows the holder to lock in a certain amount in profit while retaining future upside potential on the position if a trader buys a shout call option with a strike price of 100 on stock abc for one month when the stock price goes to 118 the holder of the shout option can lock in this price and have a guaranteed profit of 18 at expiry if the underlying stock goes to 125 the option pays 25 meanwhile if the stock ends at 106 at expiry the holder still receives 18 on the position range options have a payoff based on the difference between the maximum and minimum price of the underlying asset during the life of the option these options eliminate the risks associated with the entry and exit timing making them more expensive than plain vanilla and look back options 