Exotic options
Boaz Eilon ???? ?????
I am here to help you with Currency, and Commodities hedge, as well as choosing between options.
Previous study lectures:
1. All you need to know about Forwards and Futures
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2. Options- Lesson 1: Basic concepts, Black & Schultz model and implied volatility
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3. Options- Lesson 2: Options parameters
A link to a video explaining the parameters of options:
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4. Options- Lesson 3: Synthetic futures contract, Skew?utures A link to a video explaining the parameters of options:
https://www.dhirubhai.net/pulse/options-third-lesson-synthetic-futures-contract-skew-boaz-eilon/?trackingId=qZuWlZncTuaz2zTxhjdbTA%3D%3D
This article:
5. Options- Lesson 3: Exotic options
A link to the article https://www.theta1.co.il/exotic-options/
Exotic options
Exotic options allow an additional number of protection options and sometimes a cost reduction in exchange for taking another risk.
Knock In, a common exotic option with one entry barrier, the option will take effect in case the base asset price is above a certain rate in 'call' option or below a certain rate in 'put' option. If we need to buy dollars in the future and the dollar exchange rate should not rise above 3.24, we can buy a 'call' option that will take effect only if the exchange rate reaches 3.24. For such an option, we will pay less than a regular option for the same execution price.
We will differentiate between two types of knock-in options:
EKI - examination of whether or not the trigger activated the option according to the expiration rate on the day of expiration (European trigger)
RKI - the trigger will activate if during the life of the option the price touched the trigger gate even if it is returned back later. (American Trigger)
Knock Out option - An exotic option with one block. The option expires when the price reaches a certain price.
Similar to knock-in, we will differentiate between two types of knock-out options:
?EKO - the examination of whether the trigger will cancel the option will be determined according to the rate on the day of expiration (European trigger)
RKO - The canceling trigger will be activated if during the life of the option the price touched the trigger rate even if it returned later. (American Trigger)
An Asian option - an option for which the rate of expiration will be calculated according to the average price of the underlying asset over the life of the option.
The common use of exotic options would usually be to add an EKO or RKO cancel trigger to the option we bought in order to reduce the premium paid, the risk is to cancel the protection in case the cancel trigger is activated. And adding an trigger EKI or RKI to the option we wrote so that there is a certain interval between the option rate we wrote and the trigger rate. If on the expiration date the price will be in this range and no transaction is made through the option we can sell at a higher market price in case we sold a 'call' option (commitment to buy) and buy at a lower market price in case we sold a 'put' option (commitment to sell). Adding a trigger to the option we sell reduces the premium we receive.
Strategies
There are dozens of strategies, dynamic or strategies that go to expiration.
I will focus on strategies that go to expiration and only on those used to defend. To avoid confusion, I will mention only strategies that protect from a decline. If you want to protect against a price increase, you should use the opposite options, ie 'call' instead of 'put' and vice versa.
Buying a 'Put' option
In this strategy, we buy a put that gives us the right to sell an asset for a known price and date. In this way, we are protected from price drop and it is most similar to buying an insurance. If we buy an option at the money, it means that we do not have a deductible in case the price goes down. If we buy protection outside the money, for example a 'put' option on the exercise price that is 1% lower than the exchange rate today, we will pay a lower premium and thus lose less if the exchange rate rises or remains stable, but in the event of a decline we will not get the first percentage of the decline - Self-participation
The farther we buy an option, that is, the lower the exercise price is, the greater our deductible and the lower the premium paid.
Writing a call option
This is a strategy where we create a commitment to sell the asset for a known amount, price and date, usually out of the money. The premium we receive for writing a 'call' option will reduce our loss by the amount of the premium in the event of a price drop.
If we write a 'call' option in money, we will not be able to earn more than the premium we received even in case the price goes up. If we write a 'call' out of the money, we will earn the increase up to the exercise price of the option but the premium we will receive will be lower.
The problem with this strategy is that it only slightly reduces the risk and if the price drops sharply the premium we received may be insignificant in relation to the level of loss.
Cylinder - buying a 'put' option and writing a 'sound' option
In this strategy, we buy a ‘put’ for hedging against a fall but also write a ‘call’ option to fully or partially fund the cost of the 'put'.
If the skew is symmetrical around the money, the premium paid for buying the 'put' will be about the same as the money obtained from writing the 'call' at an equal upward distance and thus the strategy will not cost money (zero cost). Even if the price of the 'put' is more expensive than the price of the 'call' at the same distance, you can buy a 'put' farther from the money or write a 'call' closer so that the cost of the strategy will be zero.
This strategy creates a kind of space. With small changes in asset price, we have no protection and we are exposed to a decline until the 'puts' execution price. Similarly, we will gain the price incline until the 'calls' execution price. We did not pay much for the defense, if at all. One can look at it as a premium payment for buying protection and at the same time, insure someone else that is afraid of price increase. If the price does increase, we will earn up to the exercise price, but above that we will have to pay money to those who bought the option from us. In a price increase situation we will profit from the price increase by being able to sell the property at a higher price but above the exercise price we will also have to pay the buyer the option for any increase above the exercise price so from this point the cash flow is offset.
Option pricing can be very different from bank to bank, more than the forward pricing. This is because each bank may evaluate the future standard deviation differently and so will the option price be different
As stated, the standard deviation does not affect the price of a futures contract and therefore the pricing there is more uniform.
This is what the cylinder profit and loss graph looks like, along with buying 'Put' and writing 'Call' out of the money, for protection against decline:
The gain and loss graph of an asset with cylinder
Forward Extra
Forward Extra is a combination of buying a 'put' option at a lower rate than the forward rate that will be fully funded (transaction at no cost) by writing a 'call' option at the same execution price as the execution price of the 'put' option we bought and with an operating trigger (EKI) in higher rate. If on the closing date of the transaction the dollar exchange rate is higher than the trigger exchange rate, the option writer, ie the client, will pay the difference between the exercise rate and the dollar exchange rate.
Example - the dollar rate is 3.20 and the forward rate per year is minus 200 points. This means that a contract for the sale of dollars for another year will be determined at a rate of 3.18 since 200 points is 0.2 at the rate.
An example of the Extra Forward is the purchase of 'Put' 3.17 for one year and writing a 'European' Nook In 'call' EKI, with an exercise price of 3.17 and an operating trigger of 3.30.
The result will be that in a situation of decline the customer will sell the dollar at a rate of 3.17, only slightly lower than the regular forward rate and in return he will be able to gain from selling the dollar at a higher rate in case of increase, provided the increase is lower than 3.30. At any rate in the range 3.17-3.30 the customer will sell at the rate that will be on the day the transaction ends but if on the closing date the rate rises above 3.30, the operating trigger will take effect and the customer will sell at rate 3.17.
Cylinder extra - Cylinder extra is similar to Forward Extra but the 'call' and 'put' are not on the same execution price, the buying side of the cylinder is a standard option but the written option of the cylinder is of the European knock-in type, EKI. This creates less protection as we will not be protected until the price gets to the 'puts' equation rate we bought but it may be cheaper or provide a chance to sell at a better price. Similar to Forward Extra if the rate works in our favor, we can earn more as long as the closing rate will not be higher then the option trigger.
Example - A customer should sell dollars in a year from today, the forward rate is 3.18.
In Cylinder Extra, he will buy, for example, a 'put' on 3 for a year and write a 'call' of the European knock-in type, EKI, with an exercise price of 3.12 and an operating trigger at 3.21. If the dollar falls, he will be forced to sell it at a lower rate but if the rate falls below 3, the hedge will take effect and we will buy at 3 even if the rate is lower. In fact, we will buy at a rate that will be the same day but will receive from the option the difference between the dollar rate and ten 3 so that in the final offset he will sell at rate 3. In all range of 3 to rate 3.21 he will sell at a rate that closes at that time and can profit by selling at a higher rate. If the closing will be higher, than 3.21 the trigger will be activated and it will sell at a rate of 3.12.
Determining a strategy - Instead of setting the goal or defending, we will plan the response in various scenarios. In principle, we will wait for the rate to work in our favor, but at the same time, it will be determine in advance what will be done if the rate works against us. ??We will use Determining a strategy mainly when the price trend is in our favor and more rarely, after a significant wave with the direction of the trend, when the chances of counter movement increase, as a correction to the main trend that will allow us to get a better rate.
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