Every other characteristic of a binary option depends on the contract on which it is based, which, in turn, depends on the writer of the contract, or, with a standardized contract, upon the standard set by an exchange. Most binary options are not classified as puts or calls. Although there are exceptions, little is gained by classifying a binary option as a put or call since each option has only 2 possible values at expiration.
Instead, a typical binary option is in the money if the price of the underlying is either at the strike price or above. The maximum potential loss for the long trader is the premium paid for the option. If the trader expected the price of the underlying asset to decline, then, rather than buying a put, the trader would simply sell the binary option, taking the short position. If the trader expected the price to increase beyond a certain level by a certain time, then the trader would buy the binary option with a strike price equal to the minimum expected price at expiration.
Best-of-two options depends on 2 different securities or indexes; and better-of-two options pays off according to the better performing security or index. An Asian option synonyms: average rate option , average price option pays according to the average value of the underlying during the contract period.
A business would use this option to hedge against price increases or decreases over a certain period, but must buy and sell the underlying asset every day or more frequently than the available expiration dates for options or futures. Asian options pay off according to the following formula:. A ladder option synonyms: step-lock option allows the holder to lock in gains in the underlying during the contract period.
A lookback option pays according to the highest value reached by the underlying during the contract period. Some lookback options use the highest value reached by the underlying during the contract period to determine the amount of settlement.
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One formula for the lookback is:. A lock-out option pays if the value of the underlying does not go beyond a specified value. A double-lockout option pays if the value of the underlying asset remains confined within a specified range. A range-accrual option is similar, but it pays according to how many days the value of the underlying asset was above or below a specified value, or was confined within a specified range. Barrier options pay off if an asset reaches a certain price. Knock-in options are created with predetermined characteristics when the underlying reaches a certain price.
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Knock-out options are options that terminate if the underlying reaches a certain price. Since the option ceases to exist, there is no payoff even if the price moves back within the knock-out barrier before the original expiration. Thus, an option with a knock-out barrier has a maximum specified value and payoff.
Single-barrier options have a single trigger price that is either above or below the strike price, and double-barrier options have trigger prices that are above and below the strike price. Because the option may either not come into existence or pass out of existence, barrier options are generally cheaper than standard options, with the double-barrier option being cheapest. Most exotic FX options are barrier options. A double-trigger option , often used for insurance purposes, pays off only if 2 events occur.
A company or an insurance company will buy this option to limit losses that are very unlikely, but would be very expensive if they both occurred. An example would be if a company had a large property loss in a foreign country where changes in the foreign exchange rate made the loss much more expensive. Weather options pay off for unusual weather. 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.
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. 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. Knockin 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 a 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.
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Upon hitting the chosen lower price level, it creates a vanilla option. Knockout Options - These options are the reverse of knock-ins. With knock-outs, 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". 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.
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Lookback 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. Lookback options come in both american and european excercise. These options are quite expensive, less so for american exercise.
Exotic option
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.