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Exotic Options Explained

Exotic options are any option contracts with terms that differ from your common American or European options. They are typically more complex than regular options (called "vanilla options") so can be dangerous for the less experienced trader.

I remember when I was quite the novice trader, getting into a "barrier option" trade because it was cheap, but did so without realizing until too late that once the price of the underlying stock crossed a certain price threshhold the option was automatically cancelled and I lost my investment.

In some markets the true nature of the option type is only revealed in the option code, so please be aware of this.

Exotic options are often and most popularly traded on currency pairs but can also be traded on stock options, stock indexes, warrants and commodity options. Their appeal with traders is, that they are much cheaper than common options. But you get what you pay for - a higher risk of loss.

Three Main Exotic Options Groups

Knock-in options - where the price movement of the underlying can knock you INTO an option trade. There are four variations of this:

(1) Knock-in Calls
(2) Knock-in Puts
(3) Double knock-in calls
(4) Double knock-in puts

Once the pretermined price level is reach and you are "knocked in" then from that point onwards, the option trade then behaves like a normal "vanilla" option.

Knock-out options - where the price movment of the underlying can knock you OUT of an option trade and cancel it.

The above two exotic options are often called "barrier options" because the specified price barrier either knocks you into, or out of, an option trade.

Binary options - where the price movment of the underlying has to either touch, or not touch, a specific price. Binary options are sometimes called Digital options.

Binary options are divided into three main types:

(1) One-touch options - you profit if the price touches, or goes beyond, a specified price level before expiration.

(2) No-touch options - these pay a set amount if the underlying never trades at or beyong a specified price level.

(3) Double no-touch options - these make money if the underlying never trades beyond two specified price levels before expiration. These are best suited to range trading assets.

You may have already observed by now that binary options are just another form of barrier option.

There are also other variants of exotic options which are less well known and these include Asian options, Himalayan options, Everest options, Atlas options, Lookback options, Rainbow options and Compound options. Each have their own peculiarities and if you do a search on any of these terms, you can learn all about them if you feel the need to know.

Exotic Options - Working Examples

Here's an example of how a knock-in option might work on a currency pair. The same principle applies to any other underlying such as stocks or commodity futures.

Example:- You buy a knock-in call option on the EURUSD with
- a strike price of 1.4100
- a barrier of 1.4000
- a breakeven point of 1.4150

If the EURUSD drops down to the barrier at 1.4000, you are "knocked-in" into regular vanilla call options. After that, if the EURUSD then moves up to beyond the breakeven point before expiration date then you will be profitable. The lure for entering a trade under conditions like this would be a very cheap knock-in option price.

We could use the same parameters for a knock-out option. The terms of your vanilla option are, that as long as the price remains above 1.4000 the position will remain open. If the EURUSD drops below 1.4000, you lose. Once the EURUSD goes above the breakeven point of 1.4150 you will be profitable.

Exotic options are just another choice that the options trader has these days. You can add them to your trading repetoire because they provide ways to make money that would not be available otherwise. Some traders use exotic options to complement their regular options trades. Taking some time to become acquainted with these types of options may enhance your portfolio.

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