What are Exotic Options?

Exotic options are a type of financial instrument known as an option. An option involves traders buying and selling the option to buy or sell a financial commodity at a fixed price on a future date. Exotic options are those which have an additional variable or a complicating factor. Those which do not are known as vanilla options.

An option is a type of futures contract. This is when traders do not simply buy or sell a commodity itself. Instead they buy or sell the right to carry out a trade on a fixed future date at a fixed price, regardless of the prevailing market prices at the time. Originally this was designed to allow manufacturers and producers to protect themselves against extreme price swings caused by unpredictable commodity events such as a poor grain harvest. Today they are mainly used as a form of financial wager with traders hoping to profit from the difference between the agreed price and the actual market price at the time the contract comes due.

There are two main types of futures contract. In a standard contract, the agreement means the two sides must complete the deal on the due date. With a futures option, one side will have the right to insist the deal goes through, but does not have to exercise this right. Usually it would not exercise the right if it turns out to have incorrectly predicted the market's movements. As this is a much less risky position, the price paid to obtain a futures option is usually much higher than if the contract must be completed.

Exotic options, otherwise known as non-standardized options, are those which have additional stipulations. One example is a barrier option. This is a stipulation by which if the market price of the commodity covered by the option agreement reaches a particular level, the two sides are forced to immediately complete the contract, even though it has not reached the scheduled completion date. A variation on this would mean that if the market price reached a particular level, the contract would be abandoned automatically and not completed. The two variations, which could both exist in the same deal, protect one side from suffering excessive losses if they turn out to have misjudged future price movements.

As a general rule, exotic options are traded over-the-counter. This simply means they are set up as a private agreement between two individuals or organizations, rather than through a financial exchange. In most cases the added and variable complexity of exotic options would make it difficult or impossible to carry out through an exchange.