Updated July 11, 2023
Definition of Exotic Option
Exotic options are the non-traditional option strategy. This type of option strategy differs from the normal option strategies. Investors can customize the option strategy as per their requirements in this option strategy, is also known as a hybrid option strategy.
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.
Explanation
Exotic options are a type of options strategy that deviates from traditional approaches. They offer investors the ability to create personalized investment plans tailored to their preferences. Exotic options possess flexibility and hybrid nature, but they also entail higher risks that can potentially impact the investor’s profit percentage. Nevertheless, the customizable features of these options simplify decision-making for investors. Exotic options are relatively easier to locate in the market as they combine elements of both American and European options. Option holders can exercise the option either on or after the expiration date. Typically traded in the Over-The-Counter (OTC) market, this strategy blends the characteristics of American and European options. Comprehending the market dynamics associated with this strategy fully requires expertise due to their complex valuation.
Features of Exotic Option
- The exotic options are the hybrid option.
- The investor can enjoy both features of an American and European option, allowing them to exercise the option both on the expiration date and before the expiration date.
- It 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: In the OTC market, traders actively trade exotic options 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. To make profits from these options, individuals require specific skills and knowledge. Thus experts’ advice is necessary to understand the concept of options.
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. The expiration date allows for the exercise of this option. The Bermuda option is permitted on predetermined dates, specifically between the purchase and expiration dates.
- Basket Option: The calculation of these options is based entirely on the underlying assets and determines the weighted average of the underlying assets.
- Compound Option: The compound option strategy 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 that is found by taking the differences between the two options. These bonds are not very much in use because of the dependency factors involved.
Advantages
- 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; 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 expensive; therefore, any investor can invest in this option.
- If an investor is keen, he can make a good amount of returns from this option strategy.
- Options also have hedging options, and therefore, the investor can invest in this option strategy.
Disadvantages
- Investors are expected to have a good knowledge of the exotic option before investing because it is very complicated.
- The lack of knowledge can lead to some serious loss. Therefore, the risk factor is always there.
- Sometimes it has been seen that options are very hard to buy or sell due to the unexpected market condition.
- The pricing of options is also very rare, and thus the pricing of options can be different from different calculations.
Conclusion
Options strategy is a unique type of option strategy that contains risk, but the returns for the options are very good if the investors get a correct idea of how to invest in the option. The exotic options are very complex, and thus investors should invest their time to understand the market before investing. Customizing exotic options provides the option holder with a safe and expected investment, allowing investors to modify or customize the option strategy according to their requirements.
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