Trading in the forex market will get you acquainted with a lot of terms. “Options” is one of them. There are various kinds of options which are present in the foreign exchange trade. A few of those varieties are as follows: American, European, Exchange Traded, Over the Counter, Employee Stock, Cash Settled, Option Type by Expiration and Option Type by Underlying Security. And depending on whether you’re buying or selling the shares, the options would be called as “put” or “call” options. In this article, we’re going to talk about the concept of exotic options and the number of sub-types that it has:
First and foremost, we need to know what the term “exotic option” stands for. This option, as the name suggests, is something slightly more complicated in comparison to the common vanilla options (these, as the name suggests, is a normal call or put option which is traded on a pre-determined date. Exotic options would have a lot of triggers that would determine the profitability of the options. Also, it can have more than one underlying securities. Below are recorded a few types of exotic options: (Info credit: CornerTrader).
Compound Options: Compound options (sometimes also known as split-fee) are best described as ‘options and options’. Here, buyers purchase the right to get hold of another option at a particular price and at a pre-ordained date. What sets this apart from other options is that a compound option does not get you the right to acquire stocks, shares, currencies or other underlying assets. Some of these options are: Call-on-call, Put-on-Call, Put-on-Put or Call-on-Put. These are generally used in the fixed income and foreign exchange markets. The reason behind this is the fact that most people have insecurities about the risk insulation capacities of the options. To cite an example of the working of compound options, we can cite use of Call-on-Put options which are commonly used in the mortgage market to ward off the dangers of interest rate fluctuation.
Barrier Options: The values and/or prices of these types of options reach the level of the pre-determined prices or the time ranges. To cite an example, a barrier option should pay a five-per cent premium if it is exercised after just one month. Examples of such options are: Up-and-Out, Down-and-Out, Up-and-In and Down-and-In. The classification depends on the place from where the spot price originates. These are mainly used in foreign exchange and equity markets.
Lookback Option: These options have lots of pay-offs which depend on the underlying price of the assets over the life duration of the look back option. There are mainly two main types of lookback options – the floating strike option and the fixed strike option. Lookback used are mainly used in all the major index equities and futures. Using these provide a way for the investors to avoid being penalised by timing issues. These are typically majorly settled and dealt in by use of cash.
Chooser Options: With chooser options, the trader gets a time to decide whether they want the option to be a call option or a put one. When it comes to stocks which don’t have a dividend, traders can use a “Straddle strategy” (which involves using both a call and a put option at the exact same strike price).
Overall, exotic options are mainly used in order to ward off investment risks and protect against fluctuating interest rates.
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