Types of Options

Average Options - A path dependant option, which calculates the average of the path traversed by the asset, arithmetic or weighted. The payoff therefore is the difference between the average price of the underlying asset, over the life of the option, and the exercise price of the option.

Barrier Options - These are options that have an embedded price level, (barrier), which if reached will either create a vanilla option or eliminate the existance of a vanilla option. These are referred to as knock-ins/outs which are further explained below. The existance of predetermined price barriers in an option make the probability of pay off all the more difficult. Thus the reason a buyer purchases a barrier option is for the decreased cost and therefore increased leverage.

Basket Options - This type of option allows the buyer to combine two or more currencies and to assign a weight to each currency. The payoff is determined by the difference between a predetermined strike price and the combined weighted level of the basket of currencies chosen at the outset. The USDX futures contract can be considered as a basket of currencies, with each currency assigned a particular weight. In the otc market, however, the buyer chooses the currencies and the weight distribution.

Bermuda (Mid-Atlantic) Options - This is a type of option that is exercisable only on predetermined dates, such as every month, or every quarter. They are neither American style nor European style, hence the term, "Bermuda".

Chooser Options - Allows the buyer to determine the characteristics of an option during a predetermined set time span. As an example, during a 30 day period, the buyer can determine if the option will be a put or call, what the strike price will be, and at times even set the expiry date. After the 30 day period has elapsed, the seller must enter into an option agreement with the buyer according to the terms chosen by him. This type of option is generally quite expensive because of the flexibility afforded to the buyer.

Collapsible Swap - The collapsible swap is simply a combination of a plain vanilla swap with a swaption on that swap. A swaption is an option on the swap. In this case, the swaption gives us the right but not the obligation to enter into a swap with the same terms except that we will be buying fixed rates and receiving floating rates. The cashflows will offset and the swap will be deemed to be closed out since the swaption is with the same financial institution with whom we have contracted the swap

Compound Options - This is simply an option on an existing option.

Deferred Payment Options - This type of option is simply an american style vanilla option with a "twist". The buyer may exercise at any time, however, payment is deferred until the original expiry date. This type of option is less expensive than your standard american style vanilla option. It is also a longer term option with expiry dates normally not less than a year out.

Delayed Start Swap Just as its name suggests, the delayed start swap is a regular plain vanilla swap exchanging cash flows in one index against cash flows in another index with the exception that the start date of the swap is not immediate.

Digital Options - These are options that can be structured as a "one touch" barrier, "double no touch" barrier and "all or nothing" call/puts. The "one touch" digital provides an immediate payoff if the currency hits your selected price barrier chosen at outset. The "double no touch" provides a payoff upon expiration if the currency does not touch both the upper and lower price barriers selected at the outset. The call/put "all or nothing" digital option provides a payoff upon expiration if your option finishes in the money. It is referred to as "all or nothing" because even if your option finishes in the money by 1 pip, you receive the full payoff. Digital options are usually settled in cash.

Dual-Factor Barrier Options - This currency option has a predetermined barrier set in a different underlying market. If the barrier is hit then a payoff and/or knock-out/in is triggered. It is often used in hedging commodity price movements.

Exotic Options - This is a term used to categorize options that are not vanilla options, but rather those very options listed here. There are many other variations of exotic options than those listed in this glossary, with more being invented all of the time. This list, however, does cover the more common exotic options.

Futures Option: An option giving the buyer to buy/sell a futures contract at the strike price.

Indexed Principal Swap - The indexed principal swap is a variant in which the principal is not fixed for the life of the option but tied to the level of interest rates.

Interest-rate cap is an OTC derivative which protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate (the index or reference interest rate) exceed a specified strike rate (the cap rate). Caps are purchased for a premium, and typically have maturities between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.

Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period.

Interest rate floor - an OTC derivative which protects the holder from declines in short-term interest rates by making a payment to the holder when an underlying interest rate (the index or reference interest rate) falls below a specified strike rate (the floor rate). Floors are purchased for a premium, and typically have maturities between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.

Interest Rate Collar - A combination of an interest rate cap and an interest rate floor. The buyer of the collar purchases the cap option to limit the maximum interest rate he will pay and sells the floor option to obtain a premium to pay for the cap. The effect of the combination is to confine interest rate payments to a range bounded by the strike prices of the cap and floor options

Knock in Options - There are two kinds of knock-in options, i) up and in, and ii) down and in. With knock-in options, the buyer starts out without a vanilla option. If the buyer has selected an upper price barrier, and the currency hits that level, it creates a vanilla option with maturity date and strike price agreed upon at the outset. This would be called an up and in. The down and in option is the same as the up and in, except the currency has to reach a lower barrier. Upon hitting the chosen lower price level, it creates a vanilla option. Knock-ins/outs usually call for delivery of the underlying asset, unlike digitals, which are settled in cash.

Knockout Options - These options are the reverse of knock-ins. With knockouts, the buyer begins with a vanilla option, however, if the predetermined price barrier is hit, the vanilla option is cancelled and the seller has no further obligation. As in the knock-in option, there are two kinds, i) up and out, and ii) down and out. If the option hits the upper barrier, the option is cancelled and you lose your premium paid, thus, "up and out". If the option hits the lower price barrier, the option is cancelled, thus, "down and out".

Ladder Options - This option is similar to the Ratchet/Cliquet option, except that gains are locked in when the asset hits predefined price levels. Once hit, the gain is guaranteed even if the underlying falls back. If other levels are hit, those returns will then be guaranteed at each level.

Look back Options - This type of option affords the buyer the luxury of "looking back" during the life of the option and choosing the price level that would generate the most gain. This would be the lowest purchase price in the case of a call, and the highest sale price in the case of a put. Look back options come in both American and European exercise. These options are quite expensive, less so for American exercise.

OTC Options - What attracts those to the otc market and to the otc options market in particular is the flexibility afforded to the user. In the otc exotic option market, the participant may choose and structure the contract as desired. For hedgers, this is particularly attractive since the standardized exchange options do not offer much flexibility resulting in imperfect costly hedges. For the speculator too, there are advantages since one may take a position that exactly reflects market opinion, resulting in reduced cost.

Rainbow Options - This type of option is a combination of two or more options combined, each with its own distinct strike, maturity, etc. In order to achieve a payoff, all of the options entered into must be correct. An analogy may be a football parlay, whereby one predicts the outcome of three games. In order to win, you must get all three games correct.

Russian Option - A look back option without an expiry date. This type of option can have either an American or a Mid-Atlantic settlement.

Ratchet Options - Also known as cliquet, this type of option locks in gains based on a time cycle, such as monthly, quarterly, or semi-annually. This is accomplished by determining the price level of the currency on predetermined anniversary dates.

Swaption - An option to enter into an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in financing costs at a specified fixed rate of interest. The seller of the swaption, usually a commercial or investment bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium.

Quanto Options - This is an option designed to eliminate currency risk by effectively hedging it. It involves combining an equity option and incorporating a predetermined fx rate. Example, if the holder has an in-the-money Nikkei index call option upon expiration, the quanto option terms would trigger by converting the yen proceeds into dollars, which was specified at the outset in the quanto option contract. The rate is agreed upon at the beginning without the quantity of course, since this is an unknown at the time. This type of arrangement is ideal for international equity managers and mutual funds.

Vanilla Options - This is a term used to categorize the basic call and put options with either American or European exercise. It normally refers to the standard options traded on exchanges

Vanilla Swap a swap is simply the exchange of one payment stream for another.  The most common swap would be a fixed for floating rate interest swap.  With this contract, the interest payments on a floating rate loan would be exchanged for a fixed rate loan.  Note that a swap is basically a zero spread collar.  Swaps are also traded on commodities, currencies, and equities.