Options give investors the right but not the obligation to buy and sell shares. They come in a variety of forms that allow investors to increase flexibility when trading assets.
So, what is a Bermudan Option and why do traders use it?
A Bermudan option, also known as mid-Atlantic options, are an exotic option that can be exercised throughout any of the specified dates. Trading Bermudan options work similarly to other options styles in that traders use calls and puts on bearish and bullish trades in effort of making profit.
How Do Bermudan Options Work?
A Bermudan option is classified as an “exotic option“, since it is set to be exercised on a predetermined date. In this article, I will go over what Bermudan options are, how they work, and how these exotic options can benefit traders.
What Are Bermudan Options Used for?
Traders typically use Bermudan options to help manage and hedge portfolios against market crashes/declines. Traders use Bermudan options as a tool to determine the best moves to make in volatile trades.
This may sound familiar to its relative, American options since Bermudan options are used to reach the same goals. However, the main difference between the two is that Bermudan options are to be exercised only on specified dates. Therefore, meaning there is limited flexibility when entering into trades.
What Is an Example of a Bermudan Option?
So, let’s break down how the Bermudan option can be used by investors and how these trades benefit portfolios.
An investor decides to purchase 100 shares of ABC’s stock for $10 a share. To protect and hedge against market decline, the investor decides to purchase a Bermudan options contract. The contract has an exercise price of $9.10 which is set to complete expiration by 3 months from the purchase date.
Along with the option to exercise at every two weeks until expiration, meaning the investor can exercise for $.10 per share. This gives the investor flexibility when to use optimal dates to exercise trades, at a premium cost.
What Are Bermudan Swaptions?
A Bermudan swaption is a swaption that can be exercised on a defined number of pre-specified dates, which makes it more flexible than vanilla swaptions.
How Do Bermudan Swaptions Work?
Before we dive into understanding what a Bermudan swaption is, let’s first define what a swaption is.
A swaption is an option that allows users to enter into a swap, most commonly an interest rate swap. This gives the buyers the right to enter interest rate swaps. Swaptions are typically involved with OTC (Over-the-Counter) market trades which in turn makes them privately traded. This gives traders more flexibility over contract agreements.
Bermudan swaptions give traders the right but not the obligation to receive fixed rollover dates in a swap. They also have the same restrictions as the swap hedge held. In short, Bermudan swaptions allow for the writer of an option to engage in an interest rate swap on specified dates.
Pricing Bermudan Swaptions?
Since Bermudan options have multiple specified exercise dates, it’s difficult to define the price. Traders typically employ the Monte Carlo Simulation to generate interest rates.
Bermudan swaptions are usually less expensive than their counterpart, American Swaptions. This is due to the smaller premium cost. While this may be a huge plus to some traders the downside is that there is a smaller chance of hitting the strike price.
What Is a Structured Product?
Structured products are pre-packages investments that have assets that are then linked to interest and another derivative. Traders often use structured products with non-traditional investment strategies.
What Are Plain-Vanilla Options?
Plain-Vanilla options are just like they sound, simple. Plain-vanilla options take on the simplest form of options, swaps, bonds, and futures. The plain-vanilla option is a financial instrument that investors buy and or sell assets at a predetermined price. Meaning, investors holding have the right, but not the obligation, to exercise.
Since the plain/vanilla option is simple and has predetermined exercise dates, investors look to use them to hedge portfolios in volatile trades.
Plain-Vanilla vs. Bermudan Options
While the plain-vanilla swap lets the holder enter into the swap only on the expiration date. The Bermudan swap gives the holder the option to enter and exit at multiple points in time.
Bermudan vs. American and European Styles
Options traders need to understand the multiple factors they may face when determining trading strategies. There are multiple options styles that all traders should know.
The Bermudan style is the blend of both American and European options style. Both the American and European styles have a few similarities such as set strike prices, determined expirations, and are traded on widely used exchanges.
However, these styles are all different due to when you can exercise them. So, let’s get into what American and European options are and how they vary from the Bermudan option style.
American Options allow traders to exercise at any time before expiration. Typically, this leads American options to entail higher premiums due to its flexibility. The majority of exchange-traded options with single stocks are traded using the American Style.
In contrast, Bermudan options are to be exercised on specified dates. Meaning, they have less flexibility than American options.
European options are options that are exercised only when the contract hits its maturity. This means that the holder may only exercise their rights to sell or buy on the expiration date. You’ll find that the majority of indexes use European options for ease of calculation and accounting practices.
In contrast, Bermudan options have predetermined dates that holders can exercise their contracts. Also, Bermudan options are not commonly used and are more difficult to determine the price.
Advantages and Disadvantages of Bermudan Options
Now that we understand the knowledge behind Bermudan options, let’s go over the advantages and disadvantages of employing the Bermudan options strategy.
Benefits of Bermudan Options
- Bremudan options give investors a variety of dates to trade on.
- Investors are given more control once options are exercised.
- Bremudan options are cheaper to purchase and give more flexibility than European options.
Disadvantages of Bermudan Options
- Bermudan options have higher premium prices vs. European options making them more expensive to purchase.
- There are limited opportunities to exercise the options compared to American options.
- Typically the set dates to exercise are not at the strike price.
Determining What Style Works Best for You
Finding the best option style for your trading can be hard to determine. With many varieties, it’s important for investors to understand each factor that goes into each option’s style. Bermudan options are a basic compromise between American and European styles. With traders unsure of how they want to exercise contracts, Bermudan options may be a good tool to look into.
Looking to begin your investment journey? Did you know that financial advisors help you in reaching your financial goals? Investing can be beneficial and sustainable with the right strategies in place. Learn how a financial advisor can help you make smart investments decisions today.