Structured Products – Part 7: Appendix A – Most Common Types of Exotic Options

(Part of Master Thesis: Kocyigit, Eren, “The Use Of Retail Structured Products And Their Applications In Turkey”, Istanbul Bilgi University, 2010)

Most Common Types of Exotic Options

In this part; main features and characteristics of most common types of exotic options that are used in most of the structured products are defined shortly.

1. Asian Options

These options are also known as ‘average options’ in the market. Their payoff depends on the underlying asset’s average performance during a certain period. Since they are firstly introduced in Japan, they are known as ‘asian’ options. Main benefits of these options can be considered as being cheaper than standard options and being less risky (less volatile) then underlying asset. Main disadvantage of these options is when there is a major increase in underlying asset’s price which can lead a large profit making situation for a call option, these options’ payoff is less then call options in these kind of situations.

Asian options can be divided into several categories according to following terms;

  • Option type: Asian options can be found as asian call or asian put options.
  • Averaging type: In an asian option entire time until the maturity or parts of it can be counted for averaging. Also the prices can be taken in different periods like at the end of weeks or months.
  • Measuring type: Averaging method of an asian option can be arithmetic, geometric or weighted.

2. Compound Options

In these kinds of options the underlying asset of the option is another option, in other words; they can be defined as options on options. They are found mostly in 4 types; call on call, put on put, call on put and put on call options. Main advantage of these options can be considered as providing larger leverage then standard options. Their main disadvantage is if 2 options get exercised then the premium paid for a compound option will be more expensive than a standard option.

3. Binary Options

They are also known as all-or-nothing, bet or digital options. Basically there are 2 types of binary options;

a. Cash-or-nothing options: They can be found in call or put forms. A cash-or-nothing call option will pay a fixed amount of cash if the price at the maturity exceeds the strike price, otherwise it pays zero. Also a cash-or-nothing put option will pay a fixed amount of cash if the price at the maturity is less than the strike price, otherwise it pays zero.

b. Asset-or-nothing options: They are so similar with cash-or-nothing options. The main difference between them is; in asset-or-nothing options, the option holder receives the assets instead of cash. If the underlying asset’s price is greater than the exercise price at the maturity, then the holder of asset-or-nothing call option will receive a fixed amount of asset, otherwise holder gets nothing. Also if the underlying asset’s price is less than the exercise price at the maturity, then the holder of asset-or-nothing put option will receive a fixed amount of asset, otherwise the holder gets nothing.

4. Barrier Options

These options can be defined as ‘path depended’ options since their payoff depended on not only underlying’s price but also some pre- determined levels (called barriers). Their payoff depends on whether these barriers are breached or not. There are 2 main types of barrier options:

a. Knock-in options: These options will only come to life (activate) if the underlying asset’s price touches the predetermined barrier. After ‘knocked-in’ in other words touching the barrier, payoff of knock-in option is calculated like a standard option. According to the direction of the breaching barrier they can be divided into 2 as up-and-in (if the option activates when barrier is breached by price increase) and down- and-in options (if the option activates when barrier is breached by price decrease).

b. Knock-out options: These options will be active till a predetermined barrier and will become void if the underlying asset’s price touches this barrier. Till ‘knocked-out’ in other words touching the barrier, payoff of knock-out option is calculated like a standard option. According to the direction of the breaching barrier they can be divided into 2 as up-and-out (if the option becomes void when barrier is breached by price increase) and down-and-out options (if the option becomes void when barrier is breached by price decrease)

Barrier options can be considered as a cheaper option than standard options if the strike price, maturity and underlying asset are the same for 2 different options.

5. Best of Options

In these types of options, there is more than one underlying asset and there are predetermined observation periods which these underlying assets’ performances are observed. At the end of maturity best performances in the observation periods are determined and their average is paid to the investors. In this manner it can be told that they are type of asian options. Their main advantage is providing participation to the best performed asset and main disadvantage is if all underlying assets perform equal, these options can provide participation to only one of them. That’s why they are less costly for the investors then buying standard options for all the underlying assets of best-of-options. Best-of-options with the underlying assets that are negatively correlated are more expensive than the ones with positively correlated.

6. Basket Options

These options have all characteristics of standard options. Only difference between basket options and standard options is; standard options have a single asset as underlying when basket option have a group of assets as underlying. Composition of these asset groups can be done as tailor made according to the investor or a basket option can be linked to an index or a fund directly. For the investors; buying a basket option is less costly than buying standard options of each underlying asset of that basket option.

7. Chooser Options

These options are also known as ‘as you like it’ options and they can be classified as a type of compound options. These options give their holders the right to choose whether the option is a call or a put, at a specific time during their maturity. In other words; these options have a ‘chooser’ day in which the holder of the option choose the underlying standard option is a buy or call option at the maturity. They are cheaper then straddle strategy (buying call and put options at same strike) but more expensive than buying a single call or put option because in these options the holder has a right to choose. They are suitable for the investors who don’t have a directional view (up or down) about the underlying asset’s prices.

8. Lookback Options

In lookback options, total payoff depends on not only the final price of the underlying asset but also the minimum and maximum prices during the option’s maturity. If it is a call option, the payoff will be equal to the difference between the final price of the underlying asset and minimum price that is reached by the underlying asset during the maturity. If it is a put option, the payoff will be equal to the difference between maximum price that is reached by the underlying asset during the maturity and the final price of the underlying asset.

These options is more favorable then regular American options since the owner of lookback options doesn’t have to worry about exercising the option at the right time. The investor can look back over option’s maturity and find the most advantageous point to exercise the option. Because of this feature lookback options are more expensive than standard American options.

9. Shout Options

Holder of a shout option can lock in profits if he/she thinks the market has reached the highest (for a call) or lowest (for a put) level. The holder can ‘shouts’ for once and after he/she shouts, he/she can benefit further for the option if final price of the underlying asset finishes at a higher (for a call) or lower (for a put) level.

Because of this ‘shout’ feature they can be classified as a type of lookback options. Shout options are less expensive then lookback options but more expensive than standard options. They are favorable for the investors who want to lock in a minimum return in volatile markets. A shout option can be structured with more than one shout features; however, more shout feature will lead a more expensive option type for the investor.

10. Range Options

These options can be classified as a combination of barrier and binary options. They are not a call or a put option but they give their holders a specific payoff if the underlying asset’s price remains within a pre- determined price range. Some type of range options pay their holders a certain amount for each day the underlying asset’s price stays between the price ranges, some of them becomes void when the underlying asset’s price touches upper or lower boundary within the option’s maturity.

Range options are suitable for the investors who believe the underlying asset’s price will remain between certain price ranges. Also holder of these options knows their risk at the beginning of the issuance. The risk is equal to the premium paid to this option by the investor.

11. Ladder Options

These options are also known as Lock-in options. In these options, the strike price is periodically reset when the underlying asset reaches pre- determined trigger levels (rungs) and at the same time locking in the profit between old and new strike. Ladder options are found in the types of put and call options in the market.

A ladder call option is structured with the rungs defined above the strike and at the maturity pays out the difference between the highest rung reached during the maturity and strike. A ladder put option is structured with the rungs defined below the strike and at the maturity pays out the difference between the strike and the lowest rung reached during the maturity.

12. Forward Start Options

These option types are not purchased on the spot, but they have a future purchase date (forward start date). However, just like all other options, their premiums are paid at the beginning of the option contract, not when the forward start date arrives. They can be a forward purchase of a standard call or put option. Their strike price is determined on the forward start date. This strike is determined as the spot value of the underlying asset on the forward start date in most of the Forward Start Options.

Forward Start Options are often combined in a serious into Cliquet (Ratchet) Options.

13. Cliquet Options

These options are also known as Ratchet or Reset Options and they can be defined as a series of Forward Start Options. First option of a Cliquet Option is active immediately with a given strike price. Second option becomes active at the maturity date of the first option and new strike is set to the market value of the underlying asset on that day.

The process continues like this for each option added to a Cliquet Option. Premium for all the options are paid at once in the beginning of the entire Cliquet Options.