Non standard option

What Is a Non-Standard Option?

A non-standard option, often referred to as an exotic option, is a type of financial derivative contract that deviates from the characteristics of plain vanilla options by incorporating unique features or payout structures. Unlike standard options contracts traded on exchanges, non-standard options are typically customized to meet specific needs of investors or issuers, making them a part of the broader category of derivatives and structured finance. These bespoke instruments can involve non-traditional underlying asset types, complex conditions for exercise, or unusual payoff profiles, offering greater flexibility but also introducing more complexity.

History and Origin

The evolution of non-standard options is closely tied to the growth of financial engineering and the increasing sophistication of global financial markets. While traditional options have been traded for centuries, the concept of customizing these instruments to meet specific risk management or speculative objectives gained significant traction in the late 20th century. The term "exotic option" was popularized by academic work, notably a 1990 paper by Mark Rubinstein, which explored options with features beyond the standard call and put structures. This development reflected a market demand for more tailored solutions than those offered by conventional exchange-traded options. Bankers Trust notably developed the Asian option, a type of exotic option, in Tokyo in 1987.

Key Takeaways

• A non-standard option, or exotic option, has features more complex than plain vanilla options.
• These options are typically customized and traded over-the-counter (OTC) rather than on public exchanges.
• They can offer tailored risk and reward profiles, suitable for specific hedging or speculation strategies.
• Non-standard options often involve greater complexity in valuation and carry higher risk management considerations due to their customized nature.
• Corporate actions such as stock splits, reverse splits, or spin-offs can also lead to existing standard options becoming non-standard, altering their contract specifications¹⁴, ¹⁵.

Interpreting the Non-Standard Option

Interpreting a non-standard option requires a detailed understanding of its specific terms, as these instruments can have vastly different mechanics from standard options. Unlike a simple call option or put option with a straightforward strike price and expiration date, a non-standard option might include barrier levels, multiple observation dates, or payoffs linked to average prices or worst-case scenarios.

For example, a barrier option might become active or cease to exist if the underlying asset's price touches a specific "barrier" level. An investor holding such an option must not only consider the underlying asset's direction but also its path, or whether certain price levels are breached. This adds layers of complexity to both pricing and risk assessment, necessitating sophisticated analytical tools.

Hypothetical Example

Consider an investor, ABC Corp., that wants to hedge against a significant decline in the price of a specific commodity, but only if the price falls below a certain level. A standard put option would protect against any decline below the strike price. However, ABC Corp. might prefer a "knock-in" put non-standard option.

In this scenario:

• Underlying Asset: Crude Oil futures
• Strike Price: $70 per barrel
• Expiration Date: Six months from now
• Barrier Price: $75 per barrel (knock-in barrier)

This non-standard option would only become active if the price of crude oil touches or falls below $75 per barrel at any point before the expiration date. If the price never reaches $75, the option expires worthless, and ABC Corp. loses only the premium paid. If the price does hit $75 (or lower), the option "knocks in" and becomes a regular put option, giving ABC Corp. the right to sell crude oil at $70 per barrel on the expiration date, regardless of the market price at that time. This allows ABC Corp. to save on premium costs compared to a regular put option, as the protection is conditional.

Practical Applications

Non-standard options are employed in various areas of finance, primarily by institutional investors, corporations, and specialized trading desks. They are integral to structured products, which are complex financial instruments often combining derivatives with traditional securities to achieve specific risk-return profiles¹², ¹³.

• Corporate Hedging: Companies use non-standard options to create highly specific hedges against unique risks. For instance, an airline might use an Asian option, which pays based on the average price of fuel over a period, to smooth out its fuel cost exposure, aligning with its operational expense averaging.
• Investment Strategies: Portfolio managers may use these options to express nuanced market views or enhance returns under specific conditions. For example, a "range accrual" option might pay a coupon only when the underlying asset stays within a predefined price range, appealing to investors who anticipate sideways market movement¹¹.
• Capital Market Solutions: Investment banks design and issue non-standard options as part of complex financial solutions for clients, often in the over-the-counter (OTC) market, where customization is feasible. The International Swaps and Derivatives Association (ISDA) plays a role in standardizing documentation for these privately negotiated derivative transactions¹⁰.
• Regulatory Compliance: Some non-standard options can be structured to comply with specific regulatory requirements or to optimize tax outcomes.

Recently, with low volatility in markets, investors have looked beyond plain vanilla options for hedging, exploring instruments like lookback or re-settable put options⁹.

Limitations and Criticisms

While offering flexibility, non-standard options come with significant limitations and criticisms:

• Complexity and Opacity: Their customized nature makes them inherently more complex than standard options, often difficult for average investors to understand. This complexity can obscure underlying risks and make valuation challenging.
• Liquidity Issues: Because they are tailored to specific needs and typically traded over-the-counter (OTC), non-standard options often suffer from low liquidity. This means that finding a willing counterparty to buy or sell the option before its expiration can be difficult or result in unfavorable pricing⁷, ⁸.
• Model Risk: Pricing non-standard options often relies on sophisticated mathematical models. Discrepancies between models or inaccurate assumptions can lead to significant mispricing, a phenomenon known as model risk. The Securities and Exchange Commission (SEC) has recognized the risks associated with funds' use of complex derivatives, implementing Rule 18f-4 to establish a regulatory framework for their use by registered investment companies⁵.
• Higher Costs: The bespoke nature and complexity can lead to higher transaction costs and wider bid-ask spreads compared to exchange-traded options.
• Counterparty Risk: Since many non-standard options are traded OTC, they carry counterparty risk—the risk that the other party to the contract will default on its obligations.

Non-Standard Option vs. Plain Vanilla Option

The primary distinction between a non-standard option and a plain vanilla option lies in their features and customization.

Plain vanilla options are the foundational building blocks of the options market, offering a simple right to buy or sell an underlying asset at a specified price. Non-standard options, conversely, modify these basic elements to create highly specific risk-reward profiles, catering to unique market insights or hedging needs that a standard option cannot address.

FAQs

What causes an option to become non-standard?

An option can become non-standard due to specific corporate actions affecting the underlying stock, such as stock splits, reverse stock splits, spin-offs, mergers, acquisitions, or special dividends. ³, ⁴These events alter the standard terms of the contract, like the number of shares per contract or the strike price, converting a previously standard option into a non-standard one.

Are non-standard options regulated?

Yes, non-standard options, as a type of derivative, are subject to regulatory oversight. In the United States, the Securities and Exchange Commission (SEC) regulates the use of derivatives by registered investment companies. For example, SEC Rule 18f-4 establishes a comprehensive framework for how funds can engage in derivative transactions, including those with non-standard features.
²

Who typically trades non-standard options?

Non-standard options are typically traded by institutional investors, large corporations, and sophisticated high-net-worth individuals, often through investment banks or specialized brokers. ¹Their complexity, bespoke nature, and lower liquidity make them generally unsuitable for retail investors.

Can non-standard options be traded on exchanges?

While some basic forms of non-standard options might be listed, the vast majority are traded over-the-counter (OTC). This is because their highly customized terms do not fit the standardized requirements for exchange listing. OTC trading allows for direct negotiation between counterparties to create the specific contract terms desired.