From Plain Vanilla To Exotic: So Many Options!

While Black-Scholes helped standardize the pricing model for many types of options and revolutionize the market, most exotic options have no certain pricing model. In fact, this added level of uncertainty may be part of the attraction.

Yet even for standard options, the standard models are only considered rough guides. Assumptions like the log-normal probability distribution are shown no longer to hold true, and affects the pricing accuracy of the standard models.

Like equity options with puts and calls, standard options are referred to as "vanilla options," and for most, putting vanilla option strategies like iron condors together with strangles is more than complex enough. But for traders looking for a simple life, options have never been the place to play.

HIGH/LOW-RISK INSURANCE OPTIONS
Options are often used as insurance policies so that for a fee or premium, a party can ensure a price or hedge a risk at a cost-effective rate. In the increasingly complex financial world, the ability to do so for a pension fund, an insurance company, a mine, or a commodity consumer has become more and more vital.

The writer of the option is in effect acting as an insurance company and receives a fee for removing a risk. With a premium, he plans to cover both his return for providing this service and the cost of paying out on his option writing when an option does not expire worthless.

A good example of an option used for insurance is an Asian option. An Asian option pays out on the basis of an average price of an underlier over a set period. For instance, if you were a manufacturer of copper wire, then the ability to hedge the price of your copper deliveries over a period is valuable, as you will be able to set prices over a long period for your supply contracts while protecting your profit margins. Since the Asian option pays out on an average price over a set period, it can be used to balance the fluctuating raw material costs over a given timeframe. As far as the producer is concerned, they are willing to give up any positive benefit of a falling price in return for certainty, knowing a rising price won't create disruption. Asian options can work with arithmetic or weighted averages to suit the holder.

A Quanto option is another example of a practical solution to risk. A Quanto option hedges the currency risk element of a trade so that an instrument in one currency can be guaranteed to pay out in another. This is the kind of product that owners of large international equity portfolios find useful. A mutual fund, for instance, might want to provide a fund that tracks the British FTSE 100 index, yet does not suffer from a strengthening dollar. A Quanto option could be used to remove this risk so that the FTSE gains would translate into pro-rata dollar gains.

Yet not all options are designed for hedging and safety. For example, a compound option is a high-risk, high-reward option type, an option on an option. The effect of having an option on an option can be huge leverage. A compound option can pay out huge returns, but if they can't, they will be unlikely to pay out at all. This is the classic trade in options -- high payout versus low likelihood.

Another option type designed for the speculator is the passport option. This is where a trader pays a fee for the right to paper-trade for a period with a broker or market maker. Any profit from these paper trades is his to keep. These trades may not actually occur in the market, but the broker or market maker must pay out if the trader can make successful paper trades.

The trader calls in the trades to the counterparty under the terms of their passport option, and the trader is free to trade without using capital. If the broker has sold a passport to a winner, then the trades can be hedged by the broker. If the broker feels the trader is inexperienced, then he can simply let him or her pass and merely keep track of the paper losses as they build up.

In this situation, the trader is happy because if he makes bad trades, he can't lose more than he has spent, and if he wins, he keeps what he kills. However, such a passport is not cheap because the option writer is at significant risk if he does not hedge the trades in the market, which might prove expensive.

Rainbow options can also be considered highly speculative, as they require two or more options to pay out at all. Rather like a lottery, the failure of one component means the failure of the whole rainbow option. The more components that are needed to succeed, the less likely a winning condition is to occur.

BARRIER OPTIONS
Another class of options -- barrier options -- deals with hitting price levels. These options pay off if prices are hit or broken through.

Digital options come into this class. These have subclasses like the "one touch" option, which will pay out if a price is hit. Another type is called the "double no touch," where two price levels are selected and will pay out if neither level is touched. The "all or nothing" is yet another digital option and pays off if a level is crossed by even the slightest margin, yet won't pay any more if the price continues to go your way. Digitals are usually cash settled.

Digital options are just one kind of barrier option, but what happens when a barrier crossed is the determining feature of this option type? In classic barrier options, once the barrier is crossed, the option is turned into a standard vanilla option, which then pays out along the lines of Black-Scholes.

Knockout options are vanilla options that cancel themselves if they hit a certain price. Thus, if a price fell below a certain level or rose before a certain level, then the option would expire worthless, even though the market may become more favorable for the option holder's initial position later on. Once a knockout option occurs, game over.

Knockin options are the exact opposite. If a price level is reached, the option turns into a vanilla option at an agreed price and strike date. Unlike digital options, knockins and knockouts are usually settled in the underlying asset.

Most traders would love to have the power of hindsight, and at a price, the lookback option does just that. A lookback option lets the option owner pick the best price over the option's life at which to expire. In effect, the option is exercised at the optimal time in retrospect. A Russian option is the same but without an expiration date.

Ratchet options are a class that includes cliquet and ladder options, where returns are made when price levels are hit, but the option has a life beyond this event and resets its parameters. For example, when a level is hit in a ladder option, a payout is captured and the strike is reset to a higher level. The price must climb to the next rung to achieve an additional payout.

Each return is guaranteed, even if the price then goes against the holder. In a way, these options are like multiple digital options, where each option would represent a rung in the ladder and a separate payoff.

In a cliquet option, a new strike price is set at the end of a period, rather than a price event. This strike price is normally the price of the underlier at the start of a new period. Any previous gain is locked in. So in a cliquet, a sudden, sharply falling market may not invalidate the long-term profitability of an option because its out-of-the-money level will be zeroed at predetermined points in the options life.

OPTIONS AROUND THE WORLD
To add even more spice, there are different styles of options. For example, the Parisian option is where an option must be above a certain price for at least a certain length of time. This is like a barrier option, but with the added dimension of time. Clearly, it is harder for the instrument to be above a level for a certain minimum time, and as such, the premium on such an option would be less, or put another way, the option has more leverage.

In any event, options are either European-style, American-style or Bermudan. European options can only be exercised at expiry; American options can be exercised at any time, while Bermudan options can be exercised at certain regular dates. This can all get geographically confusing, with the possibility of coming across American Parisian Asian options or European Parisian Israeli options.

And before you ask, an Israeli option is an option that can be recalled by the issuer, which the holder can prematurely exercise. Convertible bonds are common examples, where the holders can swap the bond into stock and the company can buy the bonds back when it wishes.

There will probably never be a definitive list of exotic options, as new types will always be invented to fulfill the demands of the market. From the risk-hungry speculator to the risk-adverse corporation to the risk-trading financial institution, new types of options will be conjured up for efficiency and profit.

Meanwhile, if someone ever offers you an option on a wife or some lovely tulip bulbs, you might want to pass.

Clem Chambers is CEO of stocks and investment website, www.ADVFN.com. Clem wrote a stock column for Wired from 2000 to 2001, and is currently a columnist for many publications, including UK national newspapers The Business and The Scotsman. He is also a regular contributor for a number of UK and US financial publications, and makes frequent appearances on the BBC and CNBC Europe. He can be reached at clemcham@advfn.com.

GLOSSARY
Exotic options: A variation of the "plain vanilla" options.

Black-Scholes: A model used to calculate the value of an option. Developed in 1973 by Fischer Black and Myron Scholes, it utilizes the stock, price, strike price, expiration date, risk-free return, and the standard deviation of the stock's return.

Iron condor: Iron condors are four option spreads that combine both calls and puts.

Strangle: An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. The investor profits only if the underlying asset moves dramatically in either direction.