The human nature is such that it always gets attracted to something that is remotely achievable. The most eccentric thing about the same is that nobody likes to encounter the outrageous risks that come along with it. Deep-rooted skills and expertise are required by risk takers to achieve that seem far-flung. Investments follow the same principle. If an investor deciphers an unorthodox avenue, then it can lead to mind-boggling results.
The exotic option is the example of one such investment avenue. The name itself refers to the complexity of these options. These are traded over-the-counter. These options distinguish itself from regular options in terms of the determination of payoff, underlying asset, and when an option can be exercised. The adaptability of exotic options to discrete risk management needs of investors and diverse range of investment strategies are some of the many advantages that make them alluring.
Some of the exotic options are as follows:
a) Chooser Option-This type gives the holder of the option the right to choose/decide that whether the option will be a call or put prior to its expiration. For example- An investor can pick up a company where large variations is expected in the near future, but ambiguity exists in the direction of movement.
b) Bermuda Option-A fusion of American and European option, gets its name from the fact that geographically, Bermuda lies between US and Europe. The holder of this contract has the right to exercise the option during designated dates that fall at uniform intervals through the life of the contract.
c) Shout Option-A holder of this contract has more than one chance to “shout” i.e. lock in profits. This option gives the holder the right to continue participating without losing the profits that is already locked earlier.
d) Asian Option-These options are also called as “Average options”. This type of option is an apt choice for highly volatile stocks. In this exotic option, payoff is determined by the average price of the underlying asset during the contract period.
e) Barrier Option-In this option, payoff is determined whether the underlying asset has reached or surpassed the agreed price. There are four variants of barrier options-
Call option with a knock-in barrier-In this when underlying asset surpasses the price level which is more than strike price then difference between market price and strike price is paid.
Call option with a knock-out barrier-This terminates when the price of the underlying asset reaches above the strike price.
Put option with a knock-in barrier-In this option pays off when the price of the underlying asset falls below the strike price.
Put option with a knock-out barrier –This option ceases to exist when a certain price is reached below the strike price.
The path of using exotic options as investment vehicles has few roadblocks along with substantial advantages. Low liquidity on few exotic option markets poses a hazy picture of returns for the investors. Sometimes the transaction cost involved is too high. The bottom line is that unique features of exotic options makes them a good fit for portfolio management. The complexity of these avenues make it unwise to plunge into this world with little knowledge.
These alternatives can be followed prudently for managing diversification, but the time tested investment vehicles like debt, gold and equity should continue to hold some portion of the allocation