Understand what exotic options are in commodity markets

Learn what exotic options are, a category of derivative contracts used in commodities market operations.

March 20, 2024

hEDGEpoint Global Markets

Exotic options transactions are an alternative for reducing exposure to price volatility in the commodities market. They are therefore important in risk management and provide customized solutions for asset purchase and sale negotiations.

In this context, we have put together a complete guide in which you will understand:

  • What are exotic options?
  • How exotic options work in the commodities market.
  • Advantages and disadvantages.
  • The role of the hEDGEpoint HUB for your business.

Enjoy reading!

What are exotic options?

Exotic options are part of derivatives contracts. However, they differ from traditional options in aspects such as payment structure, maturity, and strike prices.

These options are often tailored to meet the specific needs of market participants such as producers, consumers, and commodity traders. They can have complex payment structures, alternative exercise conditions, customized expiration dates, and other terms that are not present in standard options.

They are traded over the counter (OTC) and offer greater flexibility in contract creation. In other words, transactions take place directly between the parties involved, without going through a centralized exchange.

Read more:

How do exotic options work in the commodities market?

There are several types of exotic options on the commodities market. Below, we explain each of them.

1.    Strip options

Its logic is as follows: if you have a very large volume, but spread it out over time, the risk of volatility is also diluted. Therefore, the strip option consists of several options that expire over much shorter periods, usually daily or weekly.

Let’s look at an example. Consider that you are trading a volume of 1,000 bags of corn due in 6 months (24 weeks) using a weekly call strip option.

As a result, 41.6 (1,000 / 24) bags of corn can be bought each week until the end of the contract. Each week, the reference price is checked. If it is above the strike, the call holder has the right to buy at the strike price and does so.

But if the reference price is below the strike, the option is not exercised. Therefore, at the end of the contract, the option buyer will probably not have bought the full 1,000 bags.

Thus, the volume purchased is equivalent to the weeks in which the option was exercised. In this way, participants assume the risk of a surplus of the volume produced.

2.    Binary Options/Digital

Binary, digital, or fixed-return options are a type of option with a predefined payoff. The risk of this option is related to the price of the underlying asset, as it pays a fixed amount when exercised.

Therefore, the risk is lower since the return does not vary according to the price of the underlying asset. Therefore, the fixed return is associated only with the probability of the price going up or down.

For example, imagine that an investor wants to buy a binary option on a certain asset because he has noticed a downward trend in its price. It currently stands at R$60.00. To do this, he buys a digital put with a strike of $50.00 and a predefined return of $10.00.

He paid a premium of $2.00. If the asset became worth $49.00 at expiry, the price fell compared to the strike. In other words, it brought in a profit of R$10.00, minus the premium paid for the option. This payoff is fixed and paid in cash and will be the same for any asset value below the strike on the expiration date.

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3.    Options with Barriers

Barrier options on the commodities market are a type of exotic option that has an activation price, also known as a barrier. It is this price that determines whether the option becomes active or inactive. Therefore, the validity of the option depends on the price of the asset over the time it is in force.

The barrier value can be reached from the moment the option is traded until it expires. There are two main options with barriers, Knock-In and Knock-Out.

Check out the table to see the difference between the two:



4. Asian options

The great peculiarity of Asian options is how the price of the adjacent asset is calculated. At the time of expiry of an Asian option, the spot price of the asset is not used as a reference for evaluating the exercise of the option.

It is the arithmetic average of the asset’s prices during a given period over the life of the option. This characteristic gives the Asian option a significant reduction in its exposure to the volatility of asset prices.

After all, an average is used to calculate the reference price, which helps to mitigate the impact of sudden and momentary fluctuations.

Read more:

What are the advantages and disadvantages of exotic options?

Exotic options have conditions that make them a good choice for highly personalized and flexible solutions. They broaden traders’ possibilities by allowing them to use hedging instruments that are better suited to their protection needs, for example.

In this sense, participants in the commodities market are able to adopt customized hedging tools. They can thus mitigate specific risks associated with the volatility of commodity prices, as well as exchange rate fluctuations and other risk factors.

Each option is unique and has its own model. This makes pricing difficult, especially when it comes to knowing the premium that will have to be paid and how long it will be valid. As they are not stock market assets, there is a risk of less transparency and early exit.

hEDGEpoint HUB: find all the information on derivatives in one place

The complexity of exotic options requires a thorough understanding of how they work. In this way, commodity market participants can make well-informed decisions.

For this, there is the hEDGEpoint HUB, hEDGEpoint‘s educational platform that trains the agents involved in this volatile sector. Here you will find access to all the market intelligence reports and exclusive courses, with materials to suit the most diverse levels of knowledge.

We enable our clients to assess the risks and decide which instruments are best for their business. Access the hEDGEpoint HUB and try a 1-month free trial. Start turning risks into opportunities.

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