An Introduction to Exotic Options

Options or “privileges” as they were known in early 19th Century America actually appeared on the financial scene around the same times as stocks. Initially, there were numerous problems with the trading of options. The terms of the contract were different from contract to contract, contracts had to be exercised in person, and there really was no secondary market to trade. Options were eventually standardized in regards to strike price, expiration, size, and other relevant contract terms. The problem of pricing options would also be solved in time. Fisher Black, Myron Scholes, and Robert Merton developed a model for pricing options that is known today as the Black-Scholes model. Finally, all problems seemingly fixed, the Chicago Board of Trade established the Chicago Board Options Exchange on April 26th, 1973. Today, the average daily options volume is around 4.6 million contracts compared to 200,000 contracts at the end of 1974. An option gives the owner the right to buy or sell an asset at a specified price on or before a specified expiration date. The owner is not obligated to exercise the option. In fact, sometimes it is to the owner’s benefit to simply do nothing and let the option expire. There are two basic types of options. A call option gives the investor the right to buy the underlying asset at a specified price on or before a specified expiration date. A put option gives the investor the right to sell the underlying asset a specified price on or before a specified expiration date. The strike price, set at the purchase of the option, is the price at which the owner can buy or sell the underlying asset. Options are used mainly for hedging and speculating purposes. Those who use options for hedging are protecting themselves from adverse future price movements by paying an up front fee. For example, an investor that owns 1,000 shares of company X, that is currently at $75, might want to hedge against a large price drop. The investor could purchase 10 put option contracts (100 shares each) with a strike price of $70. If the price per option was $250, then the total price of hedging would be $2,500. If the stock price were to rise to