Exotic Option

  

Categories: Derivatives, Stocks, Bonds

You were amiably chatting with your travel agent, discussing another conventional cruise, or perhaps a repeat of last year's sojourn to Disney World, when he suddenly becomes quiet and thoughtful. The mood in the room turns first awkward and then slightly ominous. Eventually, he leans in, a conspiratorial glint in his eye. "You know," he says, his voice quiet. "If you're tired of the usual holiday doldrums, I have a suggestion for you..." He pauses theatrically, and then, his voice dripping with a sense of implied danger, whispers a dark invitation: "there's always...the exotic option."

Better leave the kids at home for that one.

In financial terms, "exotic options" refer to specific types of bets that can be made in the futures market.

In general, options provide people with the right, but not the obligation, to do something at some point in the future. You might acquire an option to buy stock in a month's time at $X a share, or to sell oil at $Y a barrel.

The plain, regular, decidedly-not-exotic types of these bets are known as "vanilla" options. The most common varieties are calls and puts.

Calls allow the buyer to purchase a certain asset, like a stock or a commodity, at a certain price at a certain point of time. Like, a call option to buy 100 shares of Apple at $190 a share a month from now.

A put is the opposite bet, giving the option to sell a stock (or whatever asset) at a certain price at certain point in time. Like a put for the sale of 200 barrels of oil at $72 a barrel.

Exotic options are the ones that get weird. Because the definition is basically "non-standard option," the category includes pretty much anything that's off the beaten track. Sometimes financial firms create options to order for particular clients. Sometimes, exotic options consist of a combination of other options (say, a call at one strike price and a put at a different price).

Exotic options tend to be more complex, and tend to point to more specific scenarios. Not just "I'll make money if the stock goes up above $25," but something like "I'll make money if the stock rises above $25 but doesn't reach $30, with a hedge in place if the stock falls anywhere below $20."

Related or Semi-related Video

Finance: What are stock options in 90 se...0 Views

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Finance allah shmoop what are stock options in ninety seconds

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or less Here's a stock ibm not the tech company

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This one makes an anti constipation drug It's trading at

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one hundred eighty bucks a share Okay so here's an

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option of buy a share of ibm anytime in roughly

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the next three months For one hundred ninety dollars a

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share it's called a call option If you really believe

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the ibm will go to say two hundred dollars a

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share in the next three months well you'd be what's

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called ten dollars in the money then or then have

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a stock option or call option with a strike price

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of one hundred ninety dollars which would then have intrinsic

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value of ten bucks a share On the other end

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of the buy sell desk is the gal willing to

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sell you that call option for three bucks Three bucks

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a premium So gut check time Would you pay three

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dollars for the right to buy a share if ibm

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for ten dollars higher than where the stock's trading now

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today Meaning that to break even in the next three

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months the stock has to trade all the way up

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from one hundred eighty dollars a share to one hundred

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ninety three dollars a share jobs for you to get

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your money back but it goes to two hundred two

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share Well if you sell that option you'll have invested

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three bucks a share for a net return of seven

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bucks in just three months or less And yes we're

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ignoring commissions and taxes here because well in problems like

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this or just a in the book but three dollars

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into seven only three months Yeah that's a great score

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You'd have more than doubled your money And on an

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annualized return basis that's over a nine hundred percent dish

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return really good score but with a much more likely

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case that you spend three bucks to buy the option

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and it expires totally worthless And then you've lost your

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entire investment in that option So that's a call option

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It's evil twin is a put option So whereas a

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call options the rightto by a security to set price

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by a certain set date a put option is the

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right to sell that option We'd go into more detail

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here but we're promised ninety seconds

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