What is a Bermuda Option?
When you begin to dabble in the world of options, you’ll likely trade American options. Some traders also branch into European options. But even beyond that, there’s a whole class of exotic options to consider, each with their own quirks and nuances. Most popular among them are Bermuda options.
Bermuda options are something of a happy medium between American and European options. Also called “optimal exercise Bermuda options,” these options are advantageous for long-term investors because they’re exercisable on predetermined dates corresponding to options expiration dates. This gives investors the ability to reassess the option on those dates and either cash it out or let it ride, so to speak.
Here’s a closer look at Bermuda options: how they work, how they differ from other options and some of the pros and cons of dealing in these exotic options.
An Introduction to Exotic Options
A Bermuda option is a type of exotic option, which differs from the more common American and European options standards. Exotic options are aptly named in that they offer a bevy of unique possibilities in terms of payment structures, exercise opportunities, strike prices, expiration dates and more. Some of the more recognizable exotic options in addition to Bermudan include:
- Barrier options only become active once a security broaches a certain price threshold.
- Binary options payout all or nothing at the expiratory date, with a known risk-reward.
- Chooser options allow traders to pick whether it’s a put or a call after buying the option.
- Compound options give traders the right to buy another option at a specific date.
- Quanto options are international options that account for currency rate fluctuations.
There are also look-backs, basket options, extendable options, spreads, shouts, range options and many others. Furthermore, each has its own unique structure. They all give traders and investors the ability to tailor their derivative investments to best-suit their investment strategy and risk tolerance.
Example of How Bermuda Options Work
Bermudan options are one of the simpler exotic options. Here’s a quick example of how one might work:
Mario buys a 150-day Bermuda option for ABC Company with a strike price of $45. Mario is able to exercise the option on the first of every month. The current price of ABC Company is $40. In month two, the stock drops to $38, so Mario leaves it open. In month three, it rises to $44 and he keeps it open. And in Month four, the price is $49. Therefore, Mario exercises the option 30 days before its expiration.
This example also illustrates the conundrum of a Bermudan option. Exercising the option early allows investors to lock-in gains; however, exercising too early could leave money on the table. In the final month, the price of ABC Company could balloon to $58, which means Mario exercised too early. However, it could also drop back down to $44, leaving him out of the money altogether. Investors need to make a choice.
American vs. Bermudan Options
American options are the most flexible of all options. Traders can exercise them at any time before the expiratory period, which gives investors the power to capitalize on short-term price swings and speculation. They’re appealing for short-term traders and hedgers who wish to protect against fast-moving price fluctuations. For this reason, most traders tend to prefer American options over exotics.
Bermudan options are best-understood as a restricted type of American option, favored by long-term investors. Like American options, investors can exercise these options before the expiratory date; however, they can only exercise them on specific dates. The writer of the option specifies these dates upfront, such as the first of every month or the month-over-month anniversary of the option. They typically have longer expiratory periods as a result.
European vs. Bermudan Options
European options are different from Bermudan options in that investors can’t exercise them before the expiry date. They’re only exercised on the predetermined date, which makes them more cut-and-dry: the contract is either in the money or out of the money at culmination. In this way, European options are more of a “set it and forget it” derivative.
Bermudan options offer a little bit more leniency as to when an investor can exercise them on specific dates. They’re a good middle-ground between the total freedom of American options and the strict one-and-done nature of European options. The commonality between European and Bermuda options? They both attract long-term investors.
The chief advantage of Bermuda options is the ability to exercise them at predetermined periods against a long-term strategy. If the option exceeds your strike price early into the option’s time horizon, you can profit earlier. Or, if there’s turbulence, you can hold the option through expiration in hopes it’ll recover. Again, it offers some of the freedom of American options, while the time horizon and low premium of European options.
The major drawback of Bermuda options is that a lot can happen between predetermined exercise dates. This is especially true during earnings season. Stocks can dance above and below the strike price, leaving options holders waiting for the next period to exercise them. And, while a longer time horizon protects against short-term volatility, a bad bet on a future price can leave traders paying for options that are quickly worthless.
The Bottom Line on Exotic Options
If you’re interested in trading exotic options, Bermuda options are the place to start. They’re easy enough to understand as a middle-man between American and European options. Moreover, they offer a level of flexibility that appeals to long-term investors, rather than welcoming in the risk of short-term trades and trends. Used correctly, they’re both a great hedging tool and a profitable way to trade options.