Defining the AC-DC option


What is an AC-DC option?

An AC-DC option is a derivative that, at a future date, may be converted into a call or put option at the discretion of the holder.

Also known as a “choice option,” it is a type of exotic option, which means it has more complicated terms and is often more expensive than the traditional plain vanilla variety.

Key takeaways

  • An AC-DC or “chooser” option is an exotic option that allows the holder to decide whether the option will be exercised as a call or put option.
  • Due to its greater flexibility, this type of option will be more expensive than a comparable vanilla option.
  • AC-DC options are typically European-style and have an exercise price and expiration date, regardless of whether the option is exercised as a call or put option.

Understanding AC-DC Options

Like any option, the AC-DC option is a derivative that gives the investor the right, but not the obligation, to buy (call) or sell (put) a security at a specified price (the strike). Its main distinction lies in the fact that the investor makes the decision to buy or sell at a specific time after the option is in force, and not at the time of purchase.

The timing of the decision depends on how the option is built. Many AC-DC options are European options, which means that the decision to buy or sell can be exercised only when the instrument is about to expire. American options allow a decision to be exercised at any time before the expiration date.

AC-DC option strategies

An AC-DC option can be a very attractive instrument when an underlying security reports a high level of volatility or when there is uncertainty surrounding corporate news or developments, such as a pharmaceutical company waiting to receive approval from the Food and Drug Administration to an expensive new drug. a technology company seeking exclusive rights or patents for an innovative product, or any company involved in significant litigation. Gives the option holder the flexibility to choose the specified payout based on whether the buy or sell position is more profitable.

For example, if a security is trading above its strike price at expiration, exercising the call option is generally the most profitable. If the holder elects to exercise the option as a call option on the underlying security, the reward would be the maximum of the spot price minus the exercise price. In this scenario, the holder benefits by buying the security at a price lower than what he is selling on the market.

On the other hand, if a security trades below its strike price at expiration, exercising the put option would generally be the most profitable. If the holder elects to exercise his option as a put option on the underlying security, the reward would be the maximum of the exercise price minus the spot price. In this scenario, the holder benefits from selling the underlying security at a higher price than it is trading on the open market.

AC-DC Option Considerations

Of course, it is this flexibility that makes the AC-DC option more expensive than its simple call or put counterpart, even if they have the same underlying value. Generally, the more volatile the underlying security, the more expensive the AC-DC option.

Furthermore, AC-DC options are generally traded on alternative exchanges without the support of regulatory oversight common to simple options that are traded on major exchanges. As a result, they can carry higher risks of counterparty default.

www.investopedia.com

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Mark Holland

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