An “Exotic” Pop Quiz

When hear the word “exotic,” what’s the first thing that comes to mind? A tropical island excursion, a hand-assembled Italian sports car, or maybe a black-haired Latin beauty — now that’s what I call exotic! But, hey, who am I kidding. In my world, the term exotic brings to mind options trades.

If you haven’t heard of exotic options, you’re not alone. They definitely aren’t as well known as regular options, or even as some common and complex trading strategies like strangles and straddles.

To help you learn more about the world of exotic options, let’s take a little pop quiz. By the time you uncover the answers to these questions, I guarantee you’ll think of the term “exotic” in a whole new way.

Question 1

True of False: An exotic option can be defined as any type of option other than standard puts and calls…

Question 1 Answer: True. While the answer here is technically accurate, there is much more to exotic options than just the fact that they’re neither puts nor calls.

Question 2

In which of the following ways do exotic options differ from regular, or vanilla, options?

A) They generally trade over-the-counter (OTC) and not on an exchange
B) They can allow investors to change one type of asset for another
C) They can pay you a fixed amount of money, or the value of the underlying asset when the option expires in the money
D) None of the above
E) All of the above

Question 2 Answer: E. Different types of exotic options trade on the OTC market, and they allow investors to change one type of asset for another. They also can pay you a fixed amount of money, or the value of the underlying asset when the options expire.

Question 3

Which of the following are considered exotic options?

A) Chooser options
B) Icelandic options
C) Binary options
D) Fibonacci options
E) Both A and C
F) Both B and D

Question 3 Answer: E. Chooser options and binary options are some of the better-known exotic options. With chooser options the chooser determines if it is a call or put option only when a predetermined date is reached. Binary options pay you a fixed amount of money or the value of the underlying asset when the option expires in the money. As far as I know, there’s no such thing as Icelandic options or Fibonacci options, although there is such as thing as a Fibonacci numerical sequence used in options trading.

Question 4

True of False: Barrier options are a type of exotic option whose payoff depends on whether the underlying asset has reached or exceeded a predetermined price…

Question 4 Answer: True. The payoff on barrier options depends on whether the underlying asset has reached or exceeded a predetermined price. The right to purchase the barrier option’s underlying at an agreed strike price only kicks in when that price hits the agreed upon “barrier.” They are unlike regular options because the holder of regular options can buy the underlying asset at the strike price any time after the options position is initiated.

Question 5

Which of the following apply to binary options?

A) They are not based on sophisticated binary equations
B) They are called binary options because they are typically “all-or-nothing” trades
C) If you buy a binary call and the market closes above the strike price you will be paid the maximum gain
D) They tend to cost much less than regular options
E) Both A and D
F) Both B and C

Question 5 Answer: F. Binary options are typically “all-or-nothing” trades. If you buy a binary call and the market closes above the strike price, you are paid the maximum gain. Binary options are based on the mathematical probability theory proffered by 18th-century mathematician Jean le Rond d’Alembert.

Question 6

True or False: The most commonly used exotic options are look-back options and barrier options…

Question 6 Answer: True. We’ve already covered barrier options, and along with these the other most commonly used exotic options are look-back options. Look-back options were created by Black-Scholes-Merton model co-founder Robert Merton. These are options without a strike price. The holder of a look-back option exercises that option at the best price hit during the life of the option.

Question 7

Which of the following apply to Asian options?

A) They’re a good way to reduce volatility
B) Their payoff depends on the average price of the underlying asset over a certain period of time as opposed to at maturity
C) They also are known as an average option
D) All of the above
E) None of the above

Question 7 Answer: D. Asian options, also known as average options, pay off based on the average price of the underlying asset on a few specific dates. Because of their defined time frame, they are a good way to reduce volatility.

Question 8

True or False: Exotics called Bermuda options can only be exercised at maturity, much the same as European options…

Question 8 Answer: False. Bermuda options actually are a hybrid between American and European options. Unlike American options that are exercised at any time during a specified period, and European options that can be exercised only at maturity, Bermuda options can be exercised prior to maturity — but only on certain dates. Bermuda options are usually employed as a hedge on embedded call options found in bonds. Because callable bonds can normally only be called on certain days, investors who own them need only have a hedge in place on those specific call dates.

Question 9

Which of the following are NOT considered exotic options?

A) Execution options
B) Extendible options
C) Compound options
D) Range options
E) Spread options

Question 9 Answer: A. To the best of my knowledge, there’s no such thing as an execution option. Extendible options are regular options, except that they allow the investor to extend the expiration date. Compound options have another option as their underlying asset. Range options pay out based on the difference between the maximum and minimum price of the underlying asset during the life of the option. A spread option has the spread between two underlying assets as its underlying asset.  

Question 10

True of False: Exotic options are designed for inexperienced, risk-averse investors who are new to options trading?

Question 10 Answer: Most definitely false. If you think basic options trading is complex, then don’t even think about stepping up to the exotics. Hey, they are called exotics for a reason. They are rare, highly specialized, potentially very profitable — and usually very risky. If you’ve built a solid foundation trading options, and you are looking for something more, then by all means check out the exotics. Hopefully, today’s little pop quiz will leave much more informed than you were just a short time ago.