Looking for Something More Exotic in Your Options Trading?
When you start to dig deeper into the option trading world, you will run across terms like Plain Vanilla, Exotic, and every deviation that follows. This article will define these option trading terms so that when you run across them in your studies you will have a better understanding of the concept.
Let’s start out with Plain Vanilla. These are the basic options, Put’s, Call’s, and LEAPS. There are two categories of Plain Vanilla options based on when they can be exercised. They are:
American – These plain vanilla options can be exercised at any time during their lives. American style options are the standard equity option in the United States. However, it is important to note that geographic region has nothing to do with the style of option used.
European – These options can only be exercised at the end of their life. In other words, when you buy/sell one of these, you own it until it expires, win or lose.
Exotic options are just like they sound, a little more exotic than plain vanilla. These options are normally used between institutions and/or large traders. However, Exotics are often used by retail traders in the FX marketplace and this is where most traders run across them.
I like to think of exotics as all-or-nothing type bets as a simple way to visualize the difference. The primary Exotic, in my opinion, is the Barrier Option. The following is a brief explanation; my next article will explain several of the other popular exotic option types.
The Barrier Option – This option pays out if price meets or exceeds a certain barrier price. One touch, no touch, double touch options are examples of Barrier Options. They are very much like they sound. For example the One Touch Option pays a predetermined amount if the price of the underlying touches or surpasses a barrier.
The No Touch Option pays out if price doesn’t touch a particular price, and the Double Touch Option only pays if a higher and lower barriers are hit in the time frame for the option. It’s important to note that these options only have 2 possible outcomes: either the trader wins by price doing what was expected and thus receives a payout from the broker, or the trader loses and forfeits the premium paid to the broker.
This brings up an important point, these options are “over the counter” meaning that there is no actual market exchange involved – they are between your broker and yourself. In addition, Exotics are flexible, the trader usually picks the terms, payouts, etc then the broker will price the option and you decide if its worth it or not. There are very few fixed structure rules in the exotic options game.
In the next article, we will dig deeper into more exotic option types and how you can use them to profit.
Dave Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.