What Are Bermuda Options?
An options contract is described as an agreement between two parties where a holder has the right but not obligation to purchase or sell an underlying security. Depending on the type of options contract, the underlying security will have to be bought or sold by a seller on a specified date and at a predetermined price.
In this blog, we will talk about one of the exotic options in the financial markets—Bermuda options.
What Is a Bermuda Option?
Bermuda options are considered to be exotic options because they are a blend of European and American options. It received its name from Bermuda, a place which lies between Europe and America and is also referred to as Mid-Atlantic Options.
Bermuda options-holders can exercise them early but on pre-specified days, which is usually the same day every month. Usually, there are several specified dates before the expiry when one can exercise these contracts.
The early-exercise feature of Bermuda options is its special feature with which traders can exercise options on specific dates before the expiry. The dates are mentioned in the option’s terms and conditions and traders come to know of them when they purchase the contract.
Basic Details about Options Trading
Before we delve into how Bermuda options operate, let us quickly revise a few important points regarding options:
- As already mentioned, options are derivatives which provide holders with the right but not an obligation to buy or sell the underlying shares of stock or other assets.
- This financial transaction takes place at a certain price called the strike price. It takes place before or on the expiry date.
- While a call option enables a trader to purchase an underlying asset, a put option enables them to sell it. The day when an option holder can transfer the contract into shares is the expiry date. Traders ‘exercise’ their contract when they take part in this transaction.
How Do Bermuda Options Operate?
To understand the working of Bermuda options, it is important to touch upon the working of American and European options.
There are two common types of options contracts. Their names were mentioned above—American options and European options. Traders can exercise American options at any time starting from the date of purchase to that of expiration. But, European options can be exercised only on the date of expiration.
Bermuda options operate along the lines of American options. In other words, traders can exercise these options on pre-determined dates before expiry. The value of Bermuda options depends on a trader’s ability to gauge the future prices of a stock.
When Do Traders Choose Bermuda Options?
Let us understand when a person can use Bermuda options. You can consider investing in Bermuda options if you wish to invest in real estate for the long term. Usually, this derivative contract is ideal if a person invests in a property that will not be ready to sell for some more time.
In case there is an investor who is ready to purchase the underlying asset and cannot wait till its completion, traders can use Bermuda options to have sufficient funding when they require it.
Advantages of Bermuda Options
Listed below are the advantages of trading with Bermuda options:
- Bermuda options are much less expensive when compared to American options.
- These contracts are mostly used in forex markets and interest rate contracts.
- Traders can exercise Bermuda options on specified dates before the expiry date.
- Companies can make use of Bermuda options if they wish to be paid in foreign currencies. Moreover, they can choose to receive their payments at certain pre-decided dates. In these scenarios, companies can benefit immensely from the lower expenses of Bermuda options.
- Contrary to standard options, Bermuda options enable traders to customise their trades. These contracts are treated as over-the-counter trade products.
Disadvantages of Bermuda Options
Now, let us look at the disadvantages of Bermuda options:
- Bermuda options are more expensive than European options. If traders wish to exercise options on the expiry date, they may prefer European options instead.
- An important point you need to keep in mind is that traders can exercise Bermuda options only on certain specific dates. Unlike American options, traders cannot exercise Bermuda options at any time. However, these days might not be the ideal days to exercise these contracts.
- People who use Bermuda options need to learn complex option pricing models. Navigating these pricing models is not always a cakewalk. Moreover, traders cannot use the standard Black Scholes options pricing model to determine the fair value of Bermuda options.
- The writers of Bermuda options have a lot of control over making crucial decisions regarding when it can be exercised. Compared to the writers, the options buyer has less control.
Bermuda Options vs American Options
Check this table below to take a glance at the differences between Bermuda and American options:
|Differentiating Factors||American Options||Bermuda Options|
|Definition||Traders can exercise American options any time on or before the expiry period.||Traders can exercise Bermuda options on pre-set dates before the expiry period as well as on the expiry period.|
|Premium Cost||Their premium costs are more than Bermuda options.||Their premium costs are less compared to American options.|
|Standard/Customised||American options are standardised financial products traded on established and recognised stock exchanges.||Bermuda options are customised derivatives that are bilaterally traded.|
Important Things to Remember When Using Bermuda Options
Given below are certain important things to remember:
- The first business day of a month can be an ideal date for traders to exercise Bermuda options.
- Suppose a trader’s Bermuda call option’s strike price falls below the market price of the underlying stock. In such a situation, this trader can exercise their Bermuda options and buy shares for a smaller strike price.
- Do not forget that certain Bermuda options have limitations concerning early expiration dates. This is an important point to remember because the value of the contract may rise if the trader exercises it early, the reason being it provides the options-holder with a benefit.
In this blog, we have provided the important details of Bermuda options, which are exotic derivatives that blend the features of both American options and European options. While they are much less expensive than American options, traders who wish to use these options have to employ complex option pricing models which are difficult to implement.
Frequently Asked Questions
- Why are Bermuda options called by this name?
Considering these contracts are a blend of American and European options, it is known as Bermuda options. The name reflects the combination of their features and indicates it is an ‘in-between’ derivatives contract, just like Bermuda is located between the USA and Europe.
- Can Bermuda options-holder exercise the contract any time before expiry?
Traders can exercise Bermuda options only on pre-set dates before or on the date of expiry. In contrast, American options-holder can be exercised any time on or before expiry.
- Why are Bermuda options less expensive than American options?
Usually, Bermuda options are less expensive than American options because traders need to pay large amounts of premium for American options because of their flexibility.
- Can Bermuda options be traded on stock exchanges?
No, a trader cannot trade Bermuda options on stock exchanges. This is an important difference between American and European options. Bermuda options are customised derivatives that are bilaterally traded.