Financial Engineering? How Exotic Options Came Into Our Lives
Good to Know: What are Exotic Options
Exotic dances, exotic fruits… are they really exotic? Think about this for a moment: I live in Romania and to me a fruit from Costa Rica is exotic, but Costa Ricans will definitely not consider their fruits to be exotic. And this goes the other way as well: for a Costa Rican, a traditional Romanian alcoholic drink – “tuica” – is something exotic but to Romanians it’s just common booze (maybe too common for some as sometimes they mistake it for water). So “exotic” is relative if you look at it the way I described it, but the perspective changes when we talk about Exotic Options – those will be exotic for everyone because they are a type of option and have nothing to do with the part of the world you are from. Let’s take a closer look at exotic options and what Binary Options have to do with them.
Vanilla, Exotics and Binary – Take your pick!
Although Options are very easy to understand in their mainstream form (binary), this is just the tip of the iceberg and once you’re done reading this article you will probably be very happy you don’t have to trade other types of exotic options. But to understand exotics, we have to talk first about Vanilla Options: these are the simplest Options available, with the most standard components and the vast majority of these options are either European style or American style. Although these are the “simplest” options, the formulas used to calculate their value falls into the “instant headache” category for me. In other words, I don’t understand any of it, but if you think you can decipher it, be my guest and click here. If you clicked it, you probably had enough mathematics for a week (more like a month for me) so let’s keep it simple from here on.
Ok, Vanilla options are the simplest available and all other options are considered Exotics but according to Wikipedia, “… there is no strict definition of what is considered an exotic option” You guessed it: the calculation is even more complicated than the one used for Vanilla, but like I said, we are not going to talk about it. Instead, I’m gonna tell you that Exotics include Asian options, lookback options, Himalaya options, peroni options and our beloved Digital/Binary options. I have to say I never traded any exotic options except Binary and probably I never will. Trading other exotic options is not as simple as trading Binaries first because they are not available to the large public and second because things are not as easy as Choose asset – Choose direction – Choose expiry time – Choose investment so why go into a more complex form of trading when simplicity is the thing we love most about Binaries?
Although they are classified as exotic options, binaries are extremely simple to use and to understand, maybe even simpler than Vanilla Options because they don’t involve the Greeks. I don’t want to confuse you further by explaining what the Greeks of an option are but let me tell you, they make things a bit more complicated. For example, the Theta (one of the 5 main Greeks) affects the value of an option with the passing of time – if you are long on an asset, your portfolio will lose value with the passage of time.
The conclusion: Stick to what you know.
I hope you agree with me when I say that we don’t need any other variables added to our trading. Come on, we already have to identify trends, support and resistance levels, we have to be aware of news releases, Interest Rates, Draghi’s mood or Bernanke’s attitude towards the stimulus program. So why complicate things further by trading a Himalaya option (I honestly confess that I didn’t even knew that type of option even existed until I wrote this article) or other type of option which loses its value with the passage of time. Keep it Simple, Keep it Binary.