What Is an Exotic Option?

What Is an Exotic Option?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

An exotic option is a type of derivative in financial markets that is more complex than commonly traded options. Unlike standard or “vanilla” options – call and put options – that provide the right to buy or sell an asset at a certain price before a specific date, exotic options come with unique features that make them more tailored to an investor’s specific needs.

Typically, exotic options are characterized by their path dependency which basically refers to the fact that the payout of an exotic option is also determined by the price history of the underlying asset, not just the single price at expiration. As a result, exotic options allow investors to hedge complex types of risk that standard options can’t cover.

Despite their advantages, exotic options are also complex and can be difficult to analyze and value. They may carry additional levels of risk that are not present in standard options, and typically require a higher level of sophistication from investors.

Related Questions

1. How are Exotic Options different from Vanilla Options?

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Unlike vanilla options that have standard terms and conditions, exotic options offer more flexibility and can be customized to fit different trading strategies. They also have a more complicated structure and are often traded over-the-counter, which means they are not widely available to the general public.

2. What exactly does path-dependency mean in Exotic Options?

Path-dependency in exotic options refers to the dependence of the payout on the price history of the underlying asset. In other words, exotic options’ payouts aren’t just based on the asset’s price at expiration but also on whether it has met certain price levels during its life.

3. Where are Exotic Options traded?

Exotic options are typically traded over-the-counter (OTC). This means they are sold directly between two parties, rather than through an exchange like regular options. Because they are largely unregulated and can be customized, they are often used by large institutions and hedge funds.

4. What are some examples of Exotic Options?

There are many types of exotic options. Examples include Asian options, where the payoff depends on the average price of the asset during a certain period; Barrier options, which become active or inactive once the price reaches a certain level; and Lookback options, wherein the payoff is based on the maximum or minimum price of the asset during a certain period.

5. Why would an investor choose an Exotic Option?

Investors may choose exotic options to take advantage of their unique payout structures, which can allow for the hedging of more specific risks. It allows them to create more sophisticated strategies that are tailored to their specific investment goals and risk tolerance.