Exotic options are highly customized instruments that are usually created by the over-the-counter desks of major derivatives dealers in order to help their clients solve very specific types of business problems. These options - which typically have unusual features - are the fastest-growing segment of the options market. There are many different kinds of exotic options in existence today, and new ones are being created all the time. This article will examine a number of them and how they're used to traverse distinct financial obstacles.

First, however, let's quickly review some basic terminology that you'll need to understand the various summaries below. The begin with, an option is a contract that gives its owner (known as the long) the right - but not the obligation - to buy (for a call option) or to sell (for a put option) a certain quantity of an underlying security at a particular stated price (called the strike price). The option may be exercised by the long either during a certain period of time (this is true of an American option) or on its expiration date (indicative of a European option). The seller of an option contract (or, the short) must stand ready to sell (in the case of a call option) or to buy (if it's a put option) the underlying at the strike price if the option is exercised by the long. The seller, therefore, has a contingent obligation to either sell (call) or buy (put) if required to do so by the long. In exchange for assuming this obligation, the short is paid an up-front fee by the long, referred to as the option's price or premium.

Options that would be of value if they were exercised immediately are said to be in the money. For example, a call (buy) option that allows an investor to buy a stock for $30 a share when the stock is selling in the open market for $40 would be 'in the money.' If the option is exercised, the long could buy the stock for $30 and immediately turn around and resell it for $40, thus realizing a $10-per-share profit. On the other hand, if the market price of the stock is, say, $25, a call option with a strike price of $30 would be out of the money, because exercising this option would make no sense. Obviously, it would be foolish to use an option to buy the stock at $30 when you could purchase it for $25 in the open market.

Likewise, a put (sell) option with a strike price of $50 would be in the money if the stock's market value is $40 and out of the money if its value is $60. A long investor, with certainty, would not use an option to sell a stock at $50 when it could be sold for $60 in the open market.

Finally, if the option's strike price and the market value of the underlying security are the same or very close, the option is said to be at the money. Investors who are long either call or put options have the choice of whether or not to exercise their options and, of course, will only do so when it's to their benefit. Understand? Alright, let's get started.

Look-Back Options

Look-back options give their owners the right to buy or sell the underlying security at the most attractive price that it actually trades in the cash market over a specified period of time. This time period is typically - but not always - the same time frame as the option's life. As such, the strike prices of these options can, and do, change. When a look-back option is first created, the strike price is equal to the then-current market value. As the price of the underlying changes, the strike price is reset to whatever the lowest value is at which the underlying security trades (in the case of a call option) or whatever the highest value is at which the underlying trades (if it's a put option). Look-backs are also known as reset options, because the strike price is constantly reset to the most attractive strike reached during the time period. By their very nature, look-backs are always either at the money or in the money.

The primary business application of look-back options is to allow portfolio managers to smooth out their results. For example, in years when they have significantly outperformed their index, they may buy look-back calls and puts that expire the next year. By doing so, they'll take some of the return from the current year and use it to 'stack the deck' in their favor for the following year.

Binary Options

Binary options (also known as digitals) have a fixed payoff if the option ends up being in the money at expiration, regardless of the extent to which it is in the money. For example, let's assume a binary option is written that pays $1,000,000 if the price of ABC, Inc.'s, stock is above $75 per share at the end of one year. It doesn't matter if the stock is at 75.125 or $220 when the option expires, the payoff will still be $1,000,000. The binary option's value is computed as the payoff multiplied by the probability that the option will be in the money at expiration, discounted back to today.

Binary options have several business applications. Perhaps a company has an executive bonus program that awards its senior management $5,000,000 if its stock rises by fifty percent over the next two years. The company could hedge the cost of the compensation program by purchasing a binary option with a $5,000,000 payoff. For this option, the payoff will either be $5,000,000 if the option ends up in the money or nothing if it doesn't.

Bermuda Options

Bermuda options are a hybrid between American and European options. Unlike American options (which can be exercised at any time during a specified period) and European options (which can be exercised only at maturity), Bermuda options may be exercised prior to maturity, but only on certain dates. The most common application of these options is to hedge the embedded call options found in bonds. Since callable bonds can normally only be called on certain days, investors who own them don't need to hedge the call risk every single day - only those specific call dates.

Barrier Options

Barrier options are options that are either activated or deactivated when the price of the underlying security passes through some predefined value (the barrier). Barrier options have eight different varieties:

  • Up and in call - a call option that's activated if the price of the underlying rises above a certain price level.
  • Up and out call - a call option that's deactivated if the price of the underlying rises above a certain price level.
  • Down and in call - a call option that's activated if the price of the underlying falls below a certain price level.
  • Down and out call - a call option that's deactivated if the price of the underlying falls below a certain price level.
  • Up and in put - a put option that's activated if the price of the underlying rises above a certain price level.
  • Up and out put - a put option that's deactivated if the price of the underlying rises above a certain price level.
  • Down and in put - a put option that's activated if the price of the underlying falls below a certain price level.
  • Down and out put - a put option that's deactivated if the price of the underlying falls below a certain price level.

The value of these options is dependent not only upon the value of the underlying security at option expiration, but also the path that the underlying takes prior to expiration. They're therefore known as path-dependent options.

Restrike Options

The strike price of these options changes if the price of the underlying passes through a barrier price. They're typically written so that the strike price of calls is lowered and the strike price of puts is raised. For example, a call option's initial strike price of $100 might drop to a restrike price of $65 if the price of the underlying security falls below $75.

Asian Options

Asian options are very similar to look-backs, with the exception that while look-backs are based on the highest or lowest price over a period of time, Asians are based on an average price. These options can be divided into two categories: Asian strike options and Asian expiration options. With an Asian strike option, the strike price is not a set price; instead, it's the average of the prices at which the underlying security trades over a specified period of time. For example, the formula for the strike price of an Asian strike call option might be calculated as "the average of all of the prices at which the underlying trades between the option's inception and its expiration."

An Asian expiration option's terminal value also is not a single fixed value, but is instead the average of the prices at which the underlying trades over a specified period of time. It might be calculated in this manner: "the average of the closing prices over the final two weeks before the option expires."

Compound Options

Compound options provide their owners with the right to buy or sell another option. These options create positions with greater leverage than traditional options. There are four basic types of compound options:

  • Ca-call - the right to buy a call.
  • Pu-call - the right to sell a call.
  • Ca-put - the right to buy a put.
  • Pu-put - the right to sell a put.

There is only one common business application that compound options are used for - to hedge bids for business projects that may or may not be accepted.

Perpetual Zero Options

As the name implies, perpetual zero options never expire, and they have a strike price equal to zero. The perpetual right to buy an underlying security at a price of zero has the same value as the underlying security itself (unless the underlying pays dividends or interest). For example, the perpetual right to buy a growth stock that's currently selling at $45 for $0 is worth, obviously, $45.

Perpetual zero options are often used to extract the value of stock positions that the owner does not want to sell either for tax reasons or for corporate control motives. For instance, let's assume the founder of a technology firm owns a million shares of a stock that's selling for $30 a share. The owner's cost basis is zero, so any sale proceeds would be 100% taxable. The owner wants to free up the wealth that's in this stock position but doesn't want to actually sell the stock. So, the owner instead sells a perpetual zero strike call option against the position. By selling such an option, the owner effectively transfers all future gains or losses to the option purchaser.

Delay Options

Delay options are options in which the strike price is not set when the option is created. Instead, the strike price is set to equal the underlying's current market price at some predefined time in the future. They're often used to hedge certain types of executive options.

Chooser Options

With a chooser option, the long is provided the opportunity to decide whether the option is to be a call or a put at some time after the option is actually purchased. The 'choose date' can be any date after the option is created, up to and including its expiration date. Chooser options are used as volatility plays and are purchased when the buyer expects the volatility of the underlying security to increase, but is uncertain as to the direction.

Contingent Premium Options

These are instruments in which the long does not initially pay for the option. Instead, the long pays only if the option ends up being in the money. Any option, whether exotic or not, can become a contingent premium option by the mutual consent of the buyer and seller.

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