Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and other financial instruments to create either a hedged or speculative position. Options are financial instruments that can provide you, the individual investor, with the flexibility you need in almost any investment situation you might encounter. Options give you options. You’re not just limited to buying, selling or staying out of the market. With options, you can tailor your position to your own situation and stock market outlook. Consider the following potential benefits of options:
· You can protect stock holdings from a decline in market price
· You can increase income against current stock holdings
· You can prepare to buy stock at a lower price
· You can position yourself for a big market move even when you don’t know which way prices will move
· You can benefit from a stock price’s rise or fall without incurring the cost of buying or selling the stock outright
A stock option is a contract which conveys to its holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date. After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (or buy) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request.
There are two broad categories of stock options in option trading: standardized options and non-standardized options. Standardized options, or sometimes known as “plain-vanilla options”, are the typical call options and put options traded over the stock exchanges. Standardized options are the most commonly traded form of options and is what everyone is referring to when talking about call options and put options in options trading.
Non-standardized options are options that comes with special conditions, making them more flexible and better suited for individual investor needs.
As the additional conditions in non-standardized options can be highly complex, they are not normally traded over the stock exchanges for the purpose of option trading. This kind of non-standardized options are known as exotic options. These options are more complex than options that trade on an exchange, and generally trade over-the-counter (OTC).
For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the options is a put or call at a certain point during the option’s life. Because this type of option can change over the holding period, it is not be found on a regular exchange, which is why it is classified as an exotic option.
Other types of exotic options include: barrier options, Asian options, digital options and compound options, among others.
Types of Exotic Options
Here is a non-exhaustive list of well known exotic options:
Exotic options which determines if it is a call or put option only when a predetermined date is reached.
The brainchild of Black-Scholes-Merton model co founder, Robert C. Merton. These are exotic options without a strike price. The holder of this kind of exotic options exercise the option at the best price achieved during the life of the option.
Exotic options with two strike prices. One which was determined when the shout option was bought and another one determined at the discretion of the holder during the life of the shout option.
Exotic options which pays off based on the average price of the underlying asset on a few specific dates.
Exotic options which comes into existence or goes out of existence when certain prices has been reached.
Exotic options which pays you an amount equal to the power of the value of the underlying asset above the strike price.
Exotic options which is really a plain-vanilla option based on not one underlying asset but a group of underlying assets.
Exotic options giving the holder the right to exchange on kind of asset for another.
Exotic options which is a plain-vanilla option which allows the holder to extend the expiration date.
Exotic options which is really an option which underlying asset is another option.
Exotic options which pays out based on the difference between the maximum and minimum price of the underlying asset during the life of the option.
Exotic options which has the spread between two underlying assets as the underlying asset.
The most commonly used exotic options in option trading are the look-back options and the barrier options.