In all our articles until now we have focused on the simple put and call options also known as vanilla options and related strategies. In this last article we will focus on exotic options. Exotic options are characterized by a greater binary option increase of delta than that of the commonly traded vanilla options.
Vanilla options are considered simple since the payoff profile is continuous and is only dependent on the value of the underlying at expiry. Exotic options are everything else – which is a very large definition. Therefore, in this article we will only focus on the vanilla option with in and out features known as knock-in, knock-out, reverse-knock-in, and reverse-knock-out. Furthermore, we will look at the American digital option one-touch, no-touch, and double-no-touch. The knock-out option functions by being an ordinary vanilla option, put or call, unless a pre-specified barrier level is reached, or touched, before expiry.
The option is termed reverse if the barrier is placed where the option is in-the-money. While the purchaser of the exotic option does gain an exposure similar to the vanilla option, the pricing dynamics do change dramatically. With vanilla options, the price is always increasing with respect to the volatility parameter. However, barrier options can behave quite differently. Another class of exotics options are the American digitals also known as touch options.