Exotic options are cool
Exotic options are cool because they come in all kinds of shapes and sizes. They have extremely odd risk characteristics, can be path dependent, are difficult to price, are even more difficult to trade and require constant vigilance when hedging. Perhaps most importantly, even good options traders can blow up when trading exotics so exotics teach us to be humble, enjoy the ride and remember the world will destroy us unless we are true to ourselves.
It's best to begin at the beginning, so let's make sure we all know what an option is. An option grants the holder the right, but not the obligation, to buy or sell a particular security (the underlying) at a specified price, at some point in the future. An exotic option is an option with one or more twists on this basic formula. For example, the option may cease to exist if the price reaches a threshold, or there may be an immediate payoff if a particular price is reached.
Options, and indeed exotic options, are nothing new, they have been in use for thousands of years. All you need to create an exotic option is demand for it, chances are someone else will be willing to take the other side of the trade if the price is right. There is a direct historical line between the farmer selling options on next year's crop in ancient Babylon and a modern-day option trader surrounded by spot traders (the options trader is secretly amused at the childish antics of the spot traders, yet keeps silent since he needs them to execute his hedges. But I digress...). The few differences between then and now are that volumes today are higher, contracts are relatively standardized, options are available on practically everything (not just agricultural products) and lastly, option valuation theory has increased our understanding of options and let us price them more accurately.
Brief taxonomy of exotic options
Early Exercise options
The most commonly traded exotic options are early exercise options. These options allow you to exercise before the expiration date. An American option allows you to exercise on any day before expiry. A Bermudan option can only be exercised on certain pre-determined dates (so called because they appear and disappear like planes and ships in the Bermuda Triangle). These options are exotic because they exhibit path dependence. It's not just the underlying's price at trade and expiry date that matters, the option value and exercise criteria is also determined by all those jerky lines in the price graph.
Barrier options
These are options where a specific price level (the barrier) has an effect on the option if it is reached. A Knock Out option ceases to exist if the barrier is hit during the life of the option. A Knock In option only comes into existence if the barrier is breached during the life of the option. For example, imagine a 6-month Knock In option on a 12 month call with strike 40 on XYZ where the barrier is 35. If over the next 6 months, XYZ reaches 35 the buyer is granted a 12 month call option on XYZ with strike 40. If the barrier is in the money (for this example 50) the option is called a Kick Out or a Kick In. There are many variations on barrier options. Double Knock Outs or Double Knocks Ins have two barriers on either side of current spot. Double Knock Outs are cheaper than simple Knock Outs because there's double trouble. Double Knock Ins are more expensive than simple Knock Ins because they double your pleasure. In Protected, Windowed or Partial barrier options, the barrier disappears on certain dates. There are others with interesting names like roll-up, roll-down, barrier reset. No Virginia, I haven't heard of a knocked up option. Yet.
As you can imagine, when the underlying is close to the barrier, option traders exhibit extreme emotions because extreme changes in the value of the option occur with very small movements in the underlying's price. Your finance teacher will tell you a barrier option exhibits discontinuous delta and infinite gamma at the barrier. The important thing to remember is that these risks are almost impossible to hedge when you are close to the barrier and the healthiest thing for the option trader to do is take a deep breath and meditate. Here again exotic options teach us an important lesson, be prepared for you know not what adventures the world brings today. Close to the barrier, these options do their Bermudan impression, now you see them, now you don't. Customers like barriers because they are cheaper than standard options.
Average Rate Options
The payoff for AROs depends on the average value of the underlying over some period before expiration. They are sometimes called Asian options and are obviously very path dependent.
Lookback
Who said you can't have second chances! Lookback options are a great regret avoidance tool for people who wince at not having sold at highs, or bought at lows. A lookback option's payoff depends on the highest or lowest level the underlying has reached over the course of a defined period. So, you can buy a lookback option that gives you the right to buy stock XYZ 12 months from now at the lowest price XYZ reaches over those 12 months. A lookback of this type will of course be far more expensive than a standard 12 month option on XYZ. There is no such thing as a free lunch.
Binary or Digital options
Digital options pay out a prespecified fixed amount if the underlying is above or below a prespecified price at expiry. Their greeks start off looking like those on vanilla options, but close to expiration their exotic nature becomes apparent as their value moves with great lurches.
Compounds and Choosers
Simply put, these are options on options. A compound option contract may grant the holder the right to buy a put option at a specified price on a certain date. If the contract grants the right to choose between a put and a call, it is called a chooser option. These options are great for thrifty option traders who can't make up their mind at the moment, but know volatility is low and want to keep their options open. Compounds are rather prosaic, you just have to remember that the underlying is an option, so you'd buy a call if you expect the underlying option to rise in price (higher vol for instance) and a put if you expect the underlying to fall.
Range notes
Range notes are not truly options. Their payoff depends on the number of days that the underlying trades within a range over a specified period. On a range note with term 6 months, range 40-50 and underlying XYZ. The payoff will depend on the number of days, over 6 months, where XYZ closes within the range of 40-50.
Multi-asset options
The two most common types are basket options and Quantos. Basket options are sometimes called rainbow options, they're just options on a collection of different underlyings. Quantos are options on an asset denominated in one currency, where the payoff is converted into another currency for delivery. Baskets and Quantos are not really exotic, they're just bundles of options but I thought I'd put them in here because they have cool names.
Professional trading and the market for exotics
Exotic options are more difficult to price, value, and hedge than standard options. Typically, the most uncertain component of any option price is volatility. If you use the standard Black-Scholes pricing model, you know all other inputs (spot, time to expiry, interest rate), but volatility is uncertain. Professional option market makers know this, that is why they will often mumble a vol figure when asked for a price. Exotics have the added interesting characteristic of non-smoothness. That is, their relationship with volatility, price, etc. often looks more like a series of jagged cliffs than rolling hills.
Exotics are traded almost exclusively in the OTC market. Options exchanges do not dabble in exotics because of the low volumes and varied contracts. Since exotics are difficult to price, generally requiring customized models or numerical methods, they are not conducive to trading in the pits. Customers for exotics are generally sophisticated investors with good credit ratings, though every once in a while you will get someone who is just looking for a lottery (low premium and a low probability of a humungous pay-off) or a Nassim Taleb.
To market makers, Exotics are different because their gamma, tau, vega, delta (the greeks) look very different from those of standard options, they typically have kinks or steep slopes. Since market makers for standard options generally hold large portfolios with hundred of options, they rarely look at individual options and care only about the greek values of their overall portfolio. The greeks allow them to measure the change in their position due to changes in various factors that affect options prices. Market makers of exotic options on the other hand, care deeply about individual options they have sold, especially the barriers that need to be hedged at the right time.
The path dependence that exotics exhibit is another reason they are difficult to trade with a standard options portfolio. The real difficulty when trading exotics lies in hedging their extreme or discontinuous risk characteristics. That said, it is sometimes possible to achieve good hedges with standards or other exotics, especially if you are trading a large portfolio of exotics. For example, you can look at a barrier option as (sort of) a long call and a short digital struck at the barrier.
The writeup above conflates structured finance transactions with exotic options. Structured finance transactions are a bad idea, few customers know how to finance complex structures, and your investment bankers are more than glad to separate you from your money. In general, you should avoid customized services provided by investment banks because they charge an arm and a leg for them. Exotic options are also not toxic waste as the writeup above suggests, that's just a term cooked up by bankers to refer to illiquid junk bonds and Mortgage-Backed Securities. As we've learnt, exotic options are actually a lot of fun and have much to teach you about the force young jedi. And as they say, it's not a bad living trading exotic options if such is your calling.
I learnt a lot I know about options from John C. Hull's "Options, Futures, and Other Derivatives" and Paul Wilmott's "Derivatives".
The puns are mine, laugh at none but me.
As is standard for anything to do with money, caveat emptor.