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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:

Chooser Options
Exotic options which determines if it is a call or put option only when a predetermined date is reached.

Look-Back Options
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.

Shout Options
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.

Asian Options
Exotic options which pays off based on the average price of the underlying asset on a few specific dates.

Barrier Options
Exotic options which comes into existence or goes out of existence when certain prices has been reached.

Binary Options
Exotic options which pays you a fixed amount of money or the value of the underlying asset when the option expires in the money.

Power Options
Exotic options which pays you an amount equal to the power of the value of the underlying asset above the strike price.

Basket Options
Exotic options which is really a plain-vanilla option based on not one underlying asset but a group of underlying assets.

Exchange Options
Exotic options giving the holder the right to exchange on kind of asset for another.

Extendible Options
Exotic options which is a plain-vanilla option which allows the holder to extend the expiration date.

Compound Options
Exotic options which is really an option which underlying asset is another option.

Range Options
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.

Spread Options
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.

A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable. For instance, a stock option is a derivative because it derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from one or more interest rate indices. The value(s) from which a derivative derives its value is called its underlier(s).

Derivative instruments can be an excellent means of maximizing return on an investment, as well as successfully hedging a financial portfolio.

Since derivative instruments depend on the strength of an underlying security or set of securities, it is important to assess the current status of those securities, as well as accurately project their future movement. For example, if a bond option carries a variable rate that is tied directly to the performance of an underlying stock, the investor would want to look closely at the past history of that stock. Along with the history, the potential investor should also consider the standing of the issuer within its particular industry, and assess the potential for that stock to increase in value during the life of the option. If the prospects seem attractive, investing in the derivative is likely to be a good idea.

Derivative instruments are sometimes issued with the potential for the investor to eventually acquire shares of the underlying security. From this perspective, this means that an investment of this type can be an excellent way to hedge a portfolio against future purchases. Experienced investors often make use of hedging strategies of this type in order to maximize return while also increasing the scope and general value of the portfolio.

In order to identify derivative instruments that show promise of earning a significant return, it is a good idea to work closely with a broker who understands the nature of derivatives. This makes it easier to sort through the many options on the market, and focus on derivatives that are likely to help the investor achieve his or her personal financial goals. A competent broker is usually able to quickly identify strengths and weaknesses associated with the underlying security or securities, and accurately advise the investor of what to expect if the derivative is purchased.

By contrast, we might speak of primary instruments, although the term cash instruments is more common. A cash instrument is an instrument whose value is determined directly by markets. Stocks, commodities, currencies and bonds are all cash instruments. The distinction between cash and derivative instruments is not always precise, but it is a useful informal distinction.

Derivative instruments are categorized in various ways. One is the distinction between linear and non-linear derivatives. The former have payoff diagrams that are linear or almost linear. The latter has payoff diagrams that are highly non-linear. Such non-linearity is always due to the derivative either being an option or having an option embedded in its structure.

A somewhat arbitrary distinction is between vanilla and exotic derivatives. The former tend to be simple and more common; the latter more complicated and specialized. There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom. Usage does vary.

Exhibit 1 lists some standard derivatives and indicates the categories they fall into as stand alone (as opposed to embedded) instruments.

Standard Derivatives
Exhibit 1

Asian option: non-linear – exotic
Barrier option: non-linear – exotic
Basket option: non-linear – exotic
Binary option: non-linear – exotic
Call: non-linear – vanilla
Cap: non-linear – vanilla
Chooser option: non-linear – exotic
Compound option: non-linear – exotic
Contingent premium option: non-linear – exotic
Credit derivative: non-linear – exotic
Floor: non-linear – vanilla
Forward: linear – vanilla
Future: linear – vanilla
Lookback option: non-linear – exotic
Put: non-linear – vanilla
Quanto: non-linear – exotic
Rainbow option: non-linear – exotic
Ratchet option: non-linear – exotic
Swap: linear – vanilla
Swaption: non-linear – vanilla

Standard derivatives are listed. They are categorized as linear/non-linear and as vanilla/exotic. Usage of the vanilla/exotic distinction does vary, so some of the exotics listed above might be considered vanilla by some professionals. Basket options are an obvious example. Among rainbows, most are exotic, but spread options might be considered vanilla.