Risk Latte - Exotic Option Strategies for the current market

Exotic Option Strategies for the current market

Nikit Kothari*
June 20, 2009

Equity markets, especially the emerging market equities, have bounced back from their multi-year lows in March. There is some concern that the equity markets will retreat from these levels. However, some are still quite bullish. Here are some of the strategies that investors can pursue who are still bullish on the market.

This positive sentiment on emerging markets is accompanied by higher expected volatility resulting in expensive call options trading on emerging market baskets. A natural way of reducing the price is to reduce the vega which can be done by incorporating a continuous knock out barrier.

In case of a down and out barrier, the new structure has an overall reduced vega and is quite cheap as compared to a normal call in a highly volatile market. But most importantly the structure runs a high risk of knocking out. The problem is similar with an up and out barrier.

There can be multiple ways of reducing this barrier risk. Some of the alternative structures are as follows:

  1. Have multiple barriers at 95%, 90%, 85%, ...... and every time a barrier is hit reduce the call participation by a certain factor. The barrier becomes inactive after it has been hit once and the lowest barrier is the knock out barrier.

  2. Make call participation a function of the accrual factor. Accrual factor is the ratio of the number of days the underlying price is above a certain barrier (letís say 95%) to the total number of days between maturity and the strike date. This significantly reduces the risk of structure knocking out. Keeping barrier close to the strike ensures a very low vega as well. Participation can be obtained by rounding off the accrual factor to the first two significant digits. (For example if accrual factor is 0.67289, call participation is 67%). One can also have different participation levels for different ranges of accrual factors.

  3. Accumulators can be a good buy in such a volatile scenario but again they run the risk of quickly knocking out and same is the case with up and out calls.

It has to be noted though that recently thereís been a lot of investor losses in Asia with respect to Accumulators, primarily because of a lack of understanding by the investors of the risks inherent in these products.

*Nikit Kothari is an alumnus of Indian Institute of Technology, Kharagpur, India and has two years of experience in trading exotic derivatives. Most recently, he was with Lehman Brothers.

Disclaimer: The ideas and opinions expressed in this article are solely those of the authorís and does not reflect the ideas and opinions of Risk Latte Company or any of its member and/or employees. Risk Latte Company and/or any of its employees or members will not be responsible for any inaccuracies, errors or omissions and/or any factual inconsistencies in the article nor will it be liable for any losses, direct or indirect, arising out of the usage and applications of any of these ideas and opinions by anyone. This article appears solely for educational purposes only.

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