Before we go into the intricate details on the idea of exotic options, we first need to gain a first-hand understanding of what it really is all about. To offer a simplistic definition, ‘exotic option’ is something that is fundamentally different in terms of structure from the usual European (or American) currency pair options. It can also be defined as a calculation; regarding how or when the investor would be able to get a particular payoff. Exotic options are usually of greater complexity in comparison to the “plain vanilla” options, which make them quite interesting.
Since exotic options are complex, they engage in OTC (over-the-counter) trade. There are various types of exotic options that can be found. One of those is popularly known as the ‘chooser option’. By using this instrument, an investor gets the privilege of choosing whether the options amount to a ‘put’ or a ‘call’ at a particular point, during the time for which the option is truly valid. Since this kind of option can be altered during the holding period, it is not found on most of the exchanges such as NYSE or NASDAQ. This is precisely the reason for its demarcation as an ‘exotic’ option. Different kinds of exotic options include Asian, Chooser, Compound and Digital, among others.
Below is outlined a description of Chooser, Compound and Digital options. Read on: (Information collected from
www.cornertrader.ch )
Compound options: These give the owner the right (but don’t saddle them with the obligation) to purchase another option at a particular price on or within a specific date. Therefore, the underlying asset of an option is an equity security. Therefore, in a compound option, the underlying asset always acts as a fallback scheme. Compound options are generally of four types: call on put, put on put, call on call and put on call. These options are very frequently used in fixed income markets.
Barrier options: These are similar to plain vanilla call and put options. But unlike the former, these only become active or get extinguished when the underlying asset has touched on a particular price level. When seen from this angle, it can be noted that the value of barrier options increases or grows in leaps, instead of taking small steps. These options are usually traded in the foreign exchange and equity markets. These exotic options are of four types: down-and-out, up-and-out, down-and-in, and up-and-in. For example, a barrier option with a knock-out price of $100 may be written on a stock that is currently trading at $80. The option will behave like normal prices ranging from $80 to $99.99, but once the underlying stock's price hits $100, the option gets knocked-out and becomes worthless.
Chooser options: These provide the owner with a particular period of time, in order to decide whether the option owned will become a European call option or a European put option. These types of options are generally used in the equity market, especially where indices are concerned. Chooser options are a great choice when speculations predict big price fluctuations in the near future, and can usually be bought for a lower cost than a call and put option straddle.
These, in short, are the various kinds of exotic options.
