What Is a Bermuda Option?

A Bermuda option is anexotic option contract that can only be exercised on a specific, predetermined date. It offers a middle ground between anAmerican option and the single exercise date of a European option. These contracts involveunderlying financial instruments, such as stocks or bonds, and specify strike prices for potential exercises. The early exercise feature allows investors to take advantage of favorable market conditions on certain dates, which can influence planning and risk management. In this article, we show you the pros and cons along with real-world examples of Bermuda options to help you understand how they work.

How Bermuda Options Function

Options contracts are financialderivatives that provide the buyer the right—but not the obligation—to transact in an underlying asset, such as shares of stock, at a distinct price—thestrike price—on or before a specified future date.

An option to buy an underlying asset is acall option. An option to sell an underlying asset is aput option. At the option's expiration, the contracts can be converted to shares, known asexercising, of the asset at the predetermined price.

There are two main types or styles of options, American and European options. American options are exercisable at any time between the purchase date and the date of expiration.European options, however, are exercised only at the date of expiration. Bermuda options are a restricted form of the American option that allows for early exercise but only at set dates.

The early exercise feature of Bermuda options allows for an investor to use the option and convert it to shares on specific dates beforeexpiry. The dates—contained in the contract's terms—are known upfront during the purchasing of the option.

Important Considerations for Bermuda Options

Some Bermuda options might allow an investor to exercise the option on the first business day of the month. So, if an investor's call option's strike price is lower than the underlying stock's market price on the first of the month, the investor can exercise and buy shares for the lower strike price. Conversely, if the investor's put option strike price is higher than the market price of the stock, the investor can sell at the strike and pick up the shares at the lower market price. Most times, the net difference iscash-settled.

However, some Bermuda options have early expiration date restrictions. For example, a Bermuda option might have the features of a European option where it cannot be exercised until the early exercise date. Following the early exercise date, the option converts to American-style options and can be exercised at any time.

The ability to exercise an option early is a benefit to the holder, and this feature adds value to the contract. Thepremium (price) on a Bermuda option will often be higher than aEuropean option with the same terms, and lower than an American option due to its limitations on early exercise.

Pros and Cons of Bermuda Options

Bermuda options have both advantages and disadvantages. They allow investors more control over exercise timing compared to American and European options, creating a hybrid contract.

Premiums for Bermuda options are typically lower than those of American options. However, Bermuda options don't have the flexibility of exercising at any time. As a result, American options are the most expensive, while European options are the cheapest since they offer the least flexibility. The cost of Bermuda options falls somewhere in between their American and European counterparts.

A drawback of Bermuda options is if an investor waits until expiration to exercise. In this case, the investor would have been better off buying the cheaper European option instead. The extra exercise dates of a Bermuda option might not always be the best times to exercise.

Real-Life Example of a Bermuda Option

Suppose an investor owns Tesla Inc. stock, bought at $250 per share, and wants protection against a price drop.

The investor buys a six-month Bermuda-style put option with a $245 strike price. The option costs $3—or $300 since each option contract represents 100 shares. The option protects the position from a decline in price below $245 for the next six months. However, the Bermuda feature allows the investor to exercise early on the first of each month beginning in month four.

The stock price falls to $200, and by the first day of the option's fourth month, the investor exercises the put option. The stock position has declined and is sold at $200 while the strike price of $245 provides a profit of $45 from the put option. The investor is effectively out of the position at $245 minus the $300 cost of the premium and any additional broker commissions.

However, if the stock price rose considerably after the option was exercised, say to $300 by the option's expiry, the investor would miss out on any of those gains. While Bermuda options allow early exercise, this decision doesn't ensure it will be the best or most profitable choice.

The Bottom Line

Bermuda options are a hybrid between American and European options, allowing exercise only on predetermined dates rather than at any time or only at expiration. They offer a middle ground for cost, with premiums generally lower than American options but higher than European ones. If you're considering Bermuda options, assess whether the scheduled exercise dates align with your goals and the market conditions. And make sure you speak with a financial advisor to determine if a Bermuda option fits into your investment strategy.