Forex Options and Exotic Options
Options are a great tool for traders during anticipated periods of market volatility. During these periods of volatility it is expected that huge drawdowns could occur. It is also during this time that prices can gap up or down so slippage during these times is expected to increase.
Forex options are not traded on an exchange so they are usually privately negotiated contracts between the FDM and the trader.
→ NOTE:
Managers who utilize these types of instruments may be subject to regulation under state investment advisory laws. Many state securities laws are written broadly so as to include “investment contacts” in the definition of “security.” While I have not personally heard of a state making a claim like this, it is not hard to see a state making such a claim.]
Barrier Forex Option
In its most basic form, the barrier option is an option which is triggered upon the happening of an event (the barrier) (i.e. a currency pair reaching a previously determined exchange rate). A double barrier option has a barrier both above and below the current market price. There are two central ways to play barrier options: knock-in or knock out.
These pay off if an asset reaches a certain price. Knock-in options are created with predetermined characteristics when the underlying reaches a certain price. 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.
Because the option may either not come into existence or pass out of existence, barrier options are generally cheaper the standard options, with the double-barrier option being cheapest. Most exotic FX options are barrier options.
Knock-in Barrier Option
The knock-in triggers an option contract upon a certain price which is hit by the currency pair. This means that there is no option contract in existence until a barrier is hit. [What does this mean for long and short?] The knock in can be structured so it is triggered upon a price increase (the up and in option) or upon a price decrease (the down and in option).
Knock-out Barrier Option
The knock-out cancels an existing option contract which will be effective unless a certain price is hit by the currency pair. Unlike a knock-in option, the knock-out option is currently in existence; it will cease to be once the barrier is hit. [What does this mean for long and short?] Like the knock-in, the knock-out can be structured to be triggered upon a price increase (the up and out) or upon a price decrease (the down and out).
Single-Barrier Options
These 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.
Double Barrier Options
[Need to include]
Compound Options
This is an option to purchase an existing option. This has two potential premiums: the first to purchase the compound option and the second to purchase the underlying option. Because there are two premiums compound options are more expensive than vanilla options. Advantage is that they provide the opportunity for large amounts of leverage and that they are cheaper (initially) than vanilla options.
A compound option or “split fee option” is an option on an option. It gives the holder the right to buy or sell another option, and are generally used for currency or fixed income markets where insecurity exists regarding the option’s risk protection. The exercise payoff of a compound option involves the value of another option. Compound options thus have two strike prices and two exercise dates. There are four types of compound options:
- call on a call
- put on a put
- call on a put
- put on a call
→ NOTE:
http://en.wikipedia.org/wiki/Barrier_option
http://www.financial-spread-betting.com/exotic-options.html
http://www.traderslog.com/forex-options.htm
http://www.forexdirectory.net/exover.html
Study Guide >> Definitions and Terminology >> Forex Exotic Options