Option Style - Non-vanilla Exercise Rights

Non-vanilla Exercise Rights

There are other, more unusual exercise styles in which the payoff value remains the same as a standard option (as in the classic American and European options above) but where early exercise occurs differently:

• A Bermuda option is an option where the buyer has the right to exercise at a set (always discretely spaced) number of times. This is intermediate between a European option—which allows exercise at a single time, namely expiry—and an American option, which allows exercise at any time (the name is a pun: Bermuda, a British overseas territory, is somewhat American and somewhat European—in terms of both option style and physical location—but is nearer to American in terms of both). For example a typical Bermudian swaption might confer the opportunity to enter into an interest rate swap. The option holder might decide to enter into the swap at the first exercise date (and so enter into, say, a ten-year swap) or defer and have the opportunity to enter in six months time (and so enter a nine-year and six-month swap); see Swaption: Valuation. Most exotic interest rate options are of Bermudian style.

• A Canary option is an option whose exercise style lies somewhere between European options and Bermudian options. (The name refers to the relative geography of the Canary Islands.) Typically, the holder can exercise the option at quarterly dates, but not before a set time period (typically one year) has elapsed. The term was coined by Keith Kline, who at the time was an agency fixed income trader at the Bank of New York.

• A capped-style option is not an interest rate cap but a conventional option with a pre-defined profit cap written into the contract. A capped-style option is automatically exercised when the underlying security closes at a price making the option's mark to market match the specified amount.

• A compound option is an option on another option, and as such presents the holder with two separate exercise dates and decisions. If the first exercise date arrives and the 'inner' option's market price is below the agreed strike the first option will be exercised (European style), giving the holder a further option at final maturity.

• A shout option allows the holder effectively two exercise dates: during the life of the option they can (at any time) "shout" to the seller that they are locking-in the current price, and if this gives them a better deal than the payoff at maturity they'll use the underlying price on the shout date rather than the price at maturity to calculate their final payoff.

• A double option gives the purchaser a composite call-and-put option (an option to either buy or sell) in a single contract. This has only ever been available in commodities markets and have never been traded on exchange.

• A swing option gives the purchaser the right to exercise one and only one call or put on any one of a number of specified exercise dates (this latter aspect is Bermudian). Penalties are imposed on the buyer if the net volume purchased exceeds or falls below specified upper and lower limits. Allows the buyer to "swing" the price of the underlying asset. Primarily used in energy trading.