Today we’re going to break down a few of the many varieties of so-called “exotic” options that exist. Broadly speaking, these all differ from “vanilla” options that are commonly traded in that they have customized terms that set them apart from either an American or a European option.
I start with Bermudan options because the name makes it easy to remember as long as you can recall that Bermuda lies roughly between the US and Europe. As such it shouldn’t be too difficult to remember that Bermudan options are a sort of middle-ground between American options – which can be exercised at any point within their term, and European options – which are only exercise-able at expiration.
Bermudan options will have a series of (usually) discretely spaced times where the option may be exercised. For example, a Bermudan option might allow exercise exactly every two weeks over the course of its time period. If not exercised at the first two week mark, the holder of the option would not be able to exercise for another two weeks, and one then have one brief opportunity to exercise before having to wait two more weeks again.
Binary Option – Digital Option – Fixed Return Option – FRO
There are a few notes to remember regarding Binary options:
- Payoff is either a fixed amount, or nothing at all
- Payoff may take the form of cash or the underlying asset, known as “cash or nothing” and “asset or nothing”
- These pretty much universally pay either zero, or 100, depending on whether or not the underlying is above the strike price
- As you may notice, this type of option presents a negative sum game after the premiums and commissions are considered – this leads to abuse and allegations that this type of option is often utilized fraudulently
On the last point, I would argue that the market is usually a negative sum game because of the combination of fees, regulatory hurdles and commissions that nearly all market players are subject to. Though Binary options present an unusually negative sum game.
The underlying asset in a Basket option is usually some kind of average or sum (may be weighted) of a “basket” of different assets. Theoretically speaking, one could select any group of underlying assets to place into a basket, which would then form the underlying asset from which the option derives its value. In practice, indices are fairly common targets for basket options.
Rainbow options are somewhat similar to basket options in that the underlying consists of a series of assets, except that they will not pay out on the entire selection of assets. A few notes:
- Composed of two or more underlying assets or risk exposures (this is the main similarity to a basket option)
- Each asset underlying the option is a “color” of the rainbow option
- Payoff may be based on the best or worst performing asset in the rainbow
- “Best of” rainbows calculate payoff on the best performing asset, ignoring all the other colors of the rainbow
- “Worst of” rainbows calculate payoff based on the worst performing asset, ignoring all the color colors of the rainbow
- Some rainbows may pay based on the performance of multiple colors, assigning each one a weight. For example, 50% of the best, 20% of the 2nd best, 20% of the 3rd best, and 10% of the 4th best performing “color” of the rainbow might be paid out.
- Sometimes used to value things like mineral deposits or other natural resources, with the price/unit and the number of units of the resource being two underlying risk exposures.