Bermuda Option: What they are and How they Work

The Bermuda Option is becoming more popular so read on to see how it works and why it’s different than more conventional types of options.

What are Options?

An option is a contract that gives an investor the right, but not the obligation, to buy or sell an underlying financial instrument like a stock, exchange-traded fund or index at a predetermined price (strike price) within a certain period of time (expiration date).

If an option reaches its expiry without being exercised, the option has no value ceases to exist.

In a very broad sense, there are two basic types of options: the call option and the put option.

Call option

A call option is an option contract that gives its holder the right, but not obligation, to buy an underlying instrument at the strike price on or before expiration.

Although there are many reasons to trade call options, most investors usually expect the price of the security they are looking to buy to move above the strike price before expiration date.

If the price of that security does increase above the amount you bought the call option for, you will be able to profit by exercising your call option and buying the security at a lower price than the market value.

Put option

A put option is an option contact that gives its holder the right, but the obligation, to sell an underlying instrument on or before expiration.

This is essentially a bet that the price of an underlying security will move below the strike price before expiry, and so you are buying the option to sell the security at a higher price than its market value.

Along with this broad classification, options are also usually categorized based on whether they are European style or American style. The names European and American have nothing to do with geographical location, but rather when traders can exercise the contracts.

Now that you know the most common categories and different types of options, let’s take a closer look at another category known as Bermuda options.

What is a Bermuda Option?

A Bermuda option is an “exotic options contract” that is exercisable only on predetermined dates, e.g. at the 5th of every month before expiration, or on expiration.

It is neither European style nor American style, hence the term, “Bermuda,” just like the remote oceanic islands of Bermuda lies between America and Europe. Bermuda options are also known as Semi-American, Mid-Atlantic, or Quasi American options.

Trading Bermuda style options works like other styles of option exercise, meaning traders can place bullish and bearish trades using either call options or put options.

Difference between Bermuda options and European/American Options

A Bermuda option is only exercisable on predetermined dates, while an American option can be exercised anytime between the purchase date and the expiry and a European option can only be exercised at maturity.
American options are traded all over the global market, mostly in exchanges like the New York Stock Exchange, while Bermuda options are mostly traded over-the-counter.
Bermuda options are derived from stocks, futures, bonds and, especially foreign currency and interest rate swaps (mostly traded over-the-counter) while American options are commonly popular with stocks, indexes, and ETFs.

Pros of Bermuda Options

The exotic feature of Bermuda options allows sellers and buyers to use the option and convert it to shares on certain dates before the expiration date.
The dates contained in a Bermuda options contract’s terms are known upfront by the seller and the buyer during the buying of the option.
Buyers of Bermuda options are given an option that is less restrictive than a European option, and less expensive than an American option.
Buyers of Bermuda options are given more control over when the options can be exercised.
These options also give investors the ability to create and buy a hybrid contract.

Cons of Bermuda Options

Bermuda options have higher premiums than European options
There is no guarantee that exercising the option early will be the most benefiting time to so

Example

An example of a Bermudan option is a bond option that can be exercised only on coupon payment dates. For example, a company may issue a two-year callable bond with a refunding provision. This issue can be called on any exercise date and replaced with a new issue at a lower rate.

The seller of a Bermuda options contact is paid to take this risk. The value of the options contract is based on the fact that the contract stipulates the price at which the underlying security will be sold or bought if the buyer so opts.

If a trader buys a $50 Bermuda call option on a stock that currently trades for $50, he will pay very little because if he turns right around and exercises the contract and then sells the stock, he won’t make any money.

If the price of the underlying stock increases, the buyer may want to exercise the contract to make a profit, fearing that the stock might drop again.

Bottom Line

Options, including Bermudan-style options, are considered a good investment strategy as they provide traders with the means to help manage the risk of hostile financial market conditions and potentially offset losses.

Traders can also use them to speculate on both positive and negative market movements of financial instruments.

They are also a good investment strategy to reduce the risk of holding long-term stocks, especially expensive ones.