Different Types of Exotic Options

Exotic options provide many opportunities for those who wish to dabble in the speculative world of options. An option gives you the right to buy or sell an asset at or before a specific point in time, at a certain price. All of the exotic options conform to those basic rules. All options work a little differently. Here are a few examples of exotic options that you could potentially invest in. 

Barrier Option

A barrier option is a special type of option that involves exceeding a pre-established barrier level. If the asset crosses the barrier, the option loses all of its value. For example, let's say that you thought that a particular security was going to go up over the next six months. However, you did not think that the price would exceed $50 per share. You could buy the barrier at $50 and if the price did not exceed that threshold, you would make money. If the price exceeded $50 per share, you would make nothing. This makes the barrier option an "all or nothing" type of investment.

Binary Option

The binary option is called a binary option because there are only two possible outcomes at the end of the holding period. You either get paid all of the winnings or you get nothing. Therefore, this is a high risk, high yield investment as well.

For example, if you purchased an option for $50 with a binary option of $5000. If after the option period is over, your option is worth $50, you earn $5000. If it is worth less or more, you earn nothing. Put in other terms: if your option expires "in the money" then you are paid a certain amount of cash. If your option expires "out of the money" then you receive nothing. 

Rainbow Option

The rainbow option is a very complex investment instrument that relies on two unknowns to get its value. While a regular option just relies on one unknown, such as the price of the stock, the rainbow option relies on two sources of unknowns to derive its value.

For example, speculators use this type of option on deposits of natural resources. If an oil discovery is made, a rainbow option places a guess on both the price of the asset and the quantity that will be discovered in the deposit. The option is valued based on both factors in the equation.

This makes the rainbow option one of the most difficult options to value. Therefore, it is only for those with a great deal of experience in investing and a very high tolerance for risk. 

Compound Option

The compound option is basically an option on top of an option. You will make money if the option that you goes well. This makes this type of option even more difficult to predict. This should only be undertaken by some of the most advanced investors as it requires a great deal of analysis.

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