What is Exotic Option?

What is an exotic option?

Exotic options are options that do not have all the properties of conventional currency options. These options include barrier options, window option, Touch, Binary, Average spleen, options on options, etc. …

“Barrier Options” – “Knock-In Options” – “Knock-Out Options“
“Kick-In Options” – “Kick-Out Options” – “Options Strategies“

Barrier options

Why a barrier?
A barrier option is a European option, whose existence is conditioned by the evolution of the spot facing barriers in the option life.

Thus, an active barrier option will be exercisable at the end only if, at least once during the life of the option, the spot reaches or exceeds an activating barrier (We say that the barrier is touched) . At the contrary, an option with deactivating barrier will permanently cease to exist one time during the option life, the spot reach the barrier.

As barriers restrict the rights associated with holding an option, a barrier option will have a premium generally inferior to a standard option with similar characteristics.

The functioning of a barrier option:
A barrier is a threshold set by the buyer of the option in accord with the seller. The evolution of the underlying facing this threshold may condition the existence of the option, in particular make it exercisable, or make it cease to exist:
– Active barrier (In): when she is touched, the option exists and has all the features of a standard option with same parameters
–  Deactivating Barrier (Out): when she is touched, the option no longer exists, and can therefore not be exercised.

In both cases, it is sufficient that the spot reach only one time the threshold of the barrier (or get over it) before the deadline to trigger activation or deactivation.

Note: An option can have multiple barriers. In this case:
– If only one of the barriers is reached, this can remove the option
– The option exists if an active barrier is touched, but none deactivating barriers have to be reached

Different types of barrier option:
By convention, we called the barrier option by combining the type of the option to the type of barrier (In / Out).

The main types of options are:
– Knock in: A barrier option is called ‘Knock in’ if the barrier is out of money (compared to the spot). For example, a ‘Call EUR USD Knock In Put’ means a EUR put USD with an activating barrier on the fall.
– Kick or Knock out: A barrier option is called ‘Kick’ if the barrier is in the currency (compared to the spot). For example, a ‘Call Put EUR USD Kick Out’ means a EUR put USD call with a deactivating barrier on the rise.

Knock-In option (option with a activating barrier out of the money)

An option is called ‘Knock-In’ when it is accompanied by an activating barrier out of the money against the spot prevailing at the conclusion of the option:
– A call a Knock-In will have a lower barrier than the spot and the strike price of the option
– A put a Knock-In will have a higher barrier than the spot and the strike price of the option

The barrier is out of money, that is to say a level where virtually the option is not exercised. The spot must touch at least once the barrier before the deadline to activate the option and make it exercisable. In return, the premium of the Knock-In option is generally lower than a conventional exchange option.

Buy of a Call EUR Put USD Knock-In:
The customer buys EUR Call (Put USD) Knock-In:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0500 (spot is at 1.0300)
Activating barrier: 1.0100
Premium: 0.35% of the nominal, or 36 bp EUR / USD

If at maturity, the spot is above 1.0500,  and if spot had touched 1.0100 during the option life, then the holder exercises the call, and buy EUR against USD at 1.0500 ( The buy price is then at 1.0536). In any contrary case, the Knock-In Call is not exercised at maturity.

Buy of a Put EUR Call USD Knock-In:
The customer buys the Put EUR (Call USD) Knock-In:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0100 (spot is at 1.0300)
Activating barrier: 1.0100
Premium: 0.26% of the nominal, or 27 bp EUR / USD

If at maturity, the spot is below 1.0100,  and if spot had touched 1.0500 during the option life, then the holder exercises the put, and sell EUR against USD at 1.0100 ( The sell price is then at 1.0073). In any contrary case, the Knock-In Put is not exercised at maturity.

NB: we built along the same lines and by symmetry profit profiles of sellers of Knock-in options. Note that the profiles of the Knock-in options are the same as those of conventional currency options, only if the barrier is reached.
If it is not:
– The operator who took position with the underlying does not have hedging
– The operator who took position without the underlying loses the profit that he would have done with a standard option, with the same parameters.

Advantages of Knock-In options:
– If you buy: premium usually lower than conventional option with the same parameters.
– If you sell: collecting premiums, and less risky to be exercised.

Risks of Knock-In options:
– If you buy: no potential hedging of the position
– If you sell: cost of the premium if the option is not activated.

Knock-Out option (option with a deactivating barrier out of the money)

An option is called ‘Knock-out’ when it is accompanied by a activating barrier out of the money against the spot prevailing at the conclusion of the option:
– A call a Knock-out will have a lower barrier than the spot and the strike price of the option
– A put a Knock-In will have a higher barrier than the spot and the strike price of the option

The barrier is out of money, that is to say a level where virtually the option is not exercised. The spot must touch at least once the barrier before the deadline to deactivate the option. In return, the premium of the Knock-out option is generally lower than a conventional exchange option.

Buy of a Call EUR Put USD Knock-Out:
The customer buys EUR Call (Put USD) Knock-Out:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0500 (spot is at 1.0300)
Deactivating barrier: 1.0000
Premium: 1.18% of the nominal, or 122 bp EUR / USD

If at maturity, the spot is above 1.0500,  and if spot had touched 1.0000 during the option life, then the holder exercises the call, and buy EUR against USD at 1.0500 ( The buy price is then at 1.0622). In any contrary case, the Knock-out Call is not exercised at maturity.

Buy of a Put EUR Call USD Knock-Out:
The customer buys the Put EUR (Call USD) Knock-Out:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0100 (spot is at 1.0300)
Deactivating barrier: 1.0600
Premium: 0.68% of the nominal, or 70 bp EUR / USD

If at maturity, the spot is below 1.0100,  and if spot had not touched 1.0600 during the option life, then the holder exercises the put, and sell EUR against USD at 1.0100 ( The sell price is then at 1.0030). In any contrary case, the Knock-out Put is not exercised at maturity.

NB: we built along the same lines and by symmetry profit profiles of sellers of Knock-out options. Note that the profiles of the Knock-out options are the same as those of conventional currency options, only if the barrier is not reached.
If it is:
– The operator who took position with the underlying does not have hedging
– The operator who took position without the underlying loses the profit that he would have done with a standard option, with the same parameters.

Advantages of Knock-out options:
– If you buy: premium usually lower than conventional option with the same parameters.
– If you sell: no potential hedging of the position

Risks of Knock-out options:
– If you buy: collecting premiums, and less risky to be exercised

Kick-in option (option with a activating barrier in the money)

An option is called ‘Kick-In’ when it is accompanied by an activating barrier in the money against the spot prevailing at the conclusion of the option:
– A call a Kick-In will have a higher barrier than the spot and the strike price of the option
– A put a Kick-In will have a lower barrier than the spot and the strike price of the option

The barrier is in the money, that is to say a level where virtually the option is exercised. The spot must touch at least once the barrier before the deadline to activate the option and make it exercisable. In return, the premium of the Kick-In option is generally lower than a conventional exchange option.

Buy of a Call EUR Put USD Kick-In:
The customer buys EUR Call (Put USD) Kick-In:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0500 (spot is at 1.0300)
Activating barrier: 1.0800
Premium: 1.23% of the nominal, or 127 bp EUR / USD

If at maturity, the spot is above 1.0500,  and if spot had touched 1.0800 during the option life, then the holder exercises the call, and buy EUR against USD at 1.0500 ( The buy price is then at 1.0627). In any contrary case, the Kick-In Call is not exercised at maturity.

Buy of a Put EUR Call USD Kick-In:
The customer buys the Put EUR (Call USD) Kick-In:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0100 (spot is at 1.0300)
Activating barrier: 0.9800
Premium: 0.72% of the nominal, or 74 bp EUR / USD

If at maturity, the spot is below 1.0100,  and if spot had touched 0.98 during the option life, then the holder exercises the put, and sell EUR against USD at 1.0100 ( The sell price is then at 1.0026). In any contrary case, the Kick-In Put is not exercised at maturity.

NB: we built along the same lines and by symmetry profit profiles of sellers of Kick-in options. Note that the profiles of the Kick-in options are the same as those of conventional currency options, only if the barrier is reached.
If it is not:
– The operator who took position with the underlying does not have hedging
– The operator who took position without the underlying loses the profit that he would have done with a standard option, with the same parameters.

Advantages of Kick-In options:
– If you buy: premium usually lower than conventional option with the same parameters.

Risks of Kick-In options:
– If you buy: no potential hedging of the position

Kick-out option (option with a deactivating barrier in the money)

An option is called ‘Kick-out’ when it is accompanied by deactivating barrier in the money against the spot prevailing at the conclusion of the option:
– A call a Kick-out will have a higher barrier than the spot and the strike price of the option
– A put a Kick-In will have a lower barrier than the spot and the strike price of the option

The barrier is in the money, that is to say a level where virtually the option is exercised. The spot must touch at least once the barrier before the deadline to deactivate the option. In return, the premium of the Kick-out option is generally lower than a conventional exchange option.

Buy of a Call EUR Put USD Kick-Out:
The customer buys EUR Call (Put USD) Kick-Out:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0500 (spot is at 1.0300)
Deactivating barrier: 1.1200
Premium: 0.63% of the nominal, or 65 bp EUR / USD

If at maturity, the spot is above 1.0500,  and if spot had not touched 1.1200 during the option life, then the holder exercises the call, and buy EUR against USD at 1.0500 ( The buy price is then at 1.0565). In any contrary case, the Kick-out Call is not exercised at maturity.

Buy of a Put EUR Call USD Kick-Out:
The customer buys the Put EUR (Call USD) Kick-Out:
Nominal: 1 M EUR
Deadline: 3 months
Strike price: 1.0100 (spot is at 1.0300)
Deactivating barrier: 0.95
Premium: 0.34% of the nominal, or 35 bp EUR / USD

If at maturity, the spot is below 1.0100,  and if spot had not touched 0.95during the option life, then the holder exercises the put, and sell EUR against USD at 1.0100 ( The sell price is then at 1.0065). In any contrary case, the Kick-out Put is not exercised at maturity.

NB: we built along the same lines and by symmetry profit profiles of sellers of Kick-out options. Note that the profiles of the Kick-out options are the same as those of conventional currency options, only if the barrier is not reached.
If it is:
– The operator who took position with the underlying does not have hedging
– The operator who took position without the underlying loses the profit that he would have done with a standard option, with the same parameters.

Advantages of Kick-out options:
– If you buy: premium usually lower than conventional option with the same parameters.
– If you sell: collecting premiums, and less risky to be exercised

Risks of Kick-out options:
– If you buy: no potential hedging of the position

Strategies on Options

All of the following strategies are presented “for buy”; You can also choose to sell. These strategies can combine the benefits of each option strategy. However, the maximum risk is related to the aggregation of risks inherent to each of these options.