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.
- 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
- 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
- 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".
- 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.
- 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
- This is simply an option on an existing option.
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.
- 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.
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.
- 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.
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.
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.
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.
- 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".
- 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
- 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.
- 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
- 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.
- 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.
- 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