Vanilla or Exotic Options
Which are better to trade, vanilla or exotic options? We define an exotic options contract as one that includes complicated business arrangements or structures as part of the bargain. Vanilla options contracts are all of the rest. In looking at vanilla or exotic options we are not differentiating European style options from American style stock options. These styles only differ in when the options contract can be executed. A closer fit to an exotic options contract is in trading compound options, the option within an option arrangement. An excellent example of an exotic option is the rainbow option.
Vanilla or Exotic Options and the Rainbow Option
A vanilla options contract gives the buyer the right to buy in the case of a call and sell in the case of a put. A vanilla stock options contract typically contains one hundred shares of stock. At issue is whether the price of the one stock will rise or fall and to what degree. One difference between vanilla and exotic options lies in rainbow options. Just as a rainbow has many colors, a rainbow option contains many sources of risk. Strictly speaking a rainbow option may only have two things that can vary but there may be more. Traders do not base the contract results on the value of each and every equity in the trade basket. Rather, as an example, payment is based on the performance of the best performing or worst performing in the basket of equities under consideration.
A slang term for the number of equities under consideration is the number of colors of the rainbow. In addition, a rainbow options trade may be a correlation trade as payment may depend upon the price relationships between various members of the set of equities. In fact, a rainbow option may not even be based on equities. These types of options are often used when dealing with deposits of natural resources. A common approach is to base the contract on resource price and resource quantity at a given point in time.