Exotic Option
A non-standard derivative with payoff conditions or structures that differ from plain vanilla put and call options.
What is Exotic Option?
Exotic options are derivatives contracts with more complex payoff structures, pricing mechanisms, or exercise features than standard European or American put and call options. They are primarily used by institutional investors, hedge funds, and corporations to tailor precise risk-management solutions or express specific market views. Major categories include barrier options (which activate or deactivate when the underlying crosses a price threshold), Asian options (whose payoff depends on the average price of the underlying over a period), binary (digital) options (which pay a fixed amount or nothing), lookback options (based on the maximum or minimum price over the option's life), and basket options (referencing a portfolio of assets).
Example
An oil producer wants to hedge its revenue if crude oil stays within a range but does not want to pay the premium of a standard put. It purchases a down-and-out barrier put with a knock-out price at $50 per barrel — the option is active unless oil falls below $50, in which case the hedge disappears automatically. This barrier reduces the premium from $3.20 to $1.90 per barrel, saving the producer $1.30 per barrel in hedging cost.
Source: CFA Institute — Exotic Options