Vanilla Option

A financial instrument that offers the holder the right, but not the duty

A vanilla option is a financial instrument that offers the holder the right, but not the duty, to purchase or sell an underlying asset at a defined price within a specific timeframe. 

Vanilla option

A vanilla option is a call or puts choice with no unique characteristics. Such opportunities are standardized if traded on an exchange like the Chicago Board Options Exchange.

Individuals, corporations, and institutional investors utilize vanilla options to hedge their exposure to an underlying asset or to bet on the price movement of a financial instrument.

Leveraging is possible for options trading, allowing investors to profit or lose with more considerable capital. Beginners should be careful with options trading, enabling traders to lose their money much quicker with leverage.

In the general classification, there are two main types of options: the European-style option that must be in the money on the expiration date to be exercised, and the American-style option that can be exercised if it is in the capital on or before the expiration date.

There are various types of options, including barrier options, Asian options, and digital options. Investors use vanilla options to hedge their exposure to an underlying asset or speculate on a financial instrument's price movement. 

There are advantages and disadvantages of trading the vanilla option:

Advantages:

  • It will be less risky to buy stock directly as options trading only requires the premium as the initial investment

  • Leveraging is possible for options trading, allowing investors to profit enormously.

Disadvantages:

  • You can lose your entire investment when the market goes against you.

  • Time restrictions are put on options trading. 

  • Options can be convoluted or perplexing to understand.

Before trading with options, let's look into the basics of vanilla options.

Fundamentals of a vanilla option

Before placing any vanilla options trades, it is necessary to understand the fundamental elements:

Puts and Calls

Calls and puts are the two primary forms of vanilla options. An individual can buy or sell an option.

For the options buyer

A call buyer has the option to purchase the underlying instrument at the strike price but not the duty. 

A put's buyer has the option to sell the instrument at the strike price but not the duty. 

For the options seller

The writer of the option is the person who sells it. 

If the call option is exercised by its owner, shorting or writing an opportunity creates an obligation to sell the instrument.

If the put option is exercised by its owner, shorting or writing an opportunity creates an obligation to acquire the instrument.

Strike price

When a derivative contract is exercised, the strike price is the price at which it can be bought or sold.

There is a strike price for every option. 

Here are the factors to affect the strike price

  • Tolerance to Risk

  • The payoff for Risk - Reward

  • Implied Volatility

  • Volume / Liquidity

Tolerance to Risk

Risk tolerance is one of the most significant factors determining the strike price. Your risk appetite will determine your choice of the strike price. 

Depending on your risk tolerance, you can choose between ITM, ATM, and OTM options contracts. The risks associated with these options are different. Option contracts favor option buyers in the money but do not favor option sellers.

The payoff for Risk - Reward

The risk tolerance parameter is linked to this. If the risk is acceptable, investors can choose an OTM contract. If you are a risk-averse investor, you can select an 'In the Money' or 'At the Money' contract.

Implied Volatility

Every stock option comes with a variable measure of volatility, such as industry fluctuations, changes in government regulations, and other worldwide events.

Liquidity

Volume is yet another crucial component in establishing the special price. The underlying asset's liquidity will aid you in determining the trade's profitability. 

If the asset has more liquidity, you can make more money before the contract's expiration date. You will not make much money when you quit a low-liquidity deal.

When the underlying price exceeds the strike price-above the strike for a call and below the strike for a put-an option acquires intrinsic value or moves into the money.

Expiry date

Both call and put options have an expiration date. The expiry date limits the amount of time the underlying asset can be traded.

When a contract expires, if not executed, it will become worthless.

Premium

The premium is the cost of purchasing the option. 

The bonus is determined by 

  • The striking price's proximity to the underlying asset's worth (in the money, out of the capital, or at the money)

  • The underlying asset's volatility

  • The expiration time

The striking price's proximity to the underlying asset's price

The special price affects the premium since the premium reflects the inherent value. There are three situations of price movement responding to options: in-the-money, out-of-the-money, and at-the-money.

In the Money (ITM)

"In the money" (ITM) refers to an inherent value option. 

As a result, ITM implies that an option has a more excellent intrinsic value at a strike price than the current market price of the underlying asset:

  • An in-the-money call option allows the holder to purchase the security at a lower price than the current market price.

  • An in-the-money put option allows the holder to sell the securities higher than the current market price.

The premium for an option generally rises as it moves closer to the money. 

Out of the money (OTM)

"Out of the money" (OTM) indicates an option contract with purely extrinsic value.

  • The strike price of an OTM call option will be greater than the underlying asset's market price. 

  • An OTM put option has a lower strike price than the underlying asset's market price.

On the other hand, the option premium falls as the option moves more out of the money.

The option premium, for example, loses intrinsic value as an option moves further out of the money, and the value is primarily derived from the time value.

At the money (ATM)

At the money (ATM) refers to when the strike price of an option is the same as the current market price of the underlying security.

At the money (ATM), calls and puts have a special price equal to or extremely close to the underlying security's current market price.

The underlying asset's volatility

The implied volatility(IV) is the predicted volatility of a stock over the option's life. 

Option premiums adjust in response to changing expectations. The supply and demand of the underlying options and the market's estimate of the share price's movement directly impact implied volatility. 

Implied volatility will rise as expectations rise or demand for an option rises. Options with significant implied volatility will have high option premiums.

Inversely, implied volatility decreases when market expectations decline or demand for an option declines. Option pricing will be lower if the implied volatility of the options is lower.

The expiration time 

The exact date and time when an options contract or other derivative becomes null and void are known as the expiration time.

When the expiration time gets closer, the premium price will fall if the option is out-of-the-money.

Other features of the Vanilla option

European style option versus American style option

For a European-style option to be exercised, the choice must be in the money on the expiration date.

It can be exercised if an American-style option is in the money on or before the expiration date.

Because they allow you to exercise any time, American options are in high demand, accounting for most of the options market. Because the expiration date is stated, it is possible to compute the loss or profit.

The risk of European Options is lower when the payment is determined by the underlying asset's current price (maturity).

Exotic alternatives

Exotic alternatives, such as barrier optionsAsian options, and digital options, are more adaptable if a vanilla option isn't the appropriate fit. 

Barrier options

A barrier option is a derivative in which the reward is contingent on the underlying asset reaching or exceeding a defined price.

Asian options

An Asian option pays out based on the average price of the underlying asset over a set period (maturity).

Digital options

A digital option, also known as a binary option, offers the opportunity of a fixed payout if the underlying market price exceeds a predetermined limit, called the strike price. 

Exotic options are more complicated than standard options and are usually traded over the counter. They can be coupled to create complex structures that lower net costs and boost leverage.

Vanilla Options Examples

Here are some examples of how vanilla options operate for both calls and puts if you consider them part of your options trading strategy.

Vanilla Call Option

A call option allows you to buy a stock at a specific price within a defined time frame. Bullish investors often purchase call options and expect a stock's price to rise.

Let's say you're interested in a stock that trades at $50, and you can buy a call option on it for $55 per share within one month. It is a stock option for 100 shares.

This option has a $0.2 premium per share. As a result, the premium would be $20. You are under no obligation to buy the shares. 

You can earn if the stock trades for more than $55.2 (option price plus premium).

A Vanilla Put Option

A put is a type of insurance that protects you if the value of your stock drops. It's one way for investors to sell a stock short. Here's an illustration.

Assume you hold 100 shares of a stock trading at $25 a share. You purchase a put option at a premium of $1 per share with a strike price of $25 that expires in two months. So you paid a total of $100 for a compensation of 100 shares.

The stock price lowers to $15 per share in a month. Because your strike price lets you sell the shares for $25 rather than $15, now is an excellent opportunity to exercise that premium. 

You wouldn't make any money because you're essentially selling the stocks for what you paid for them ($25), and you might even lose money (the $1 per share premium). 

Still, the alternative would be to lose even more money if you waited for the price to drop or didn't have the option.

Summary 

  • A "vanilla option" is a form of financial instrument that allows its holders to buy or sell an underlier, or underlying asset, at a predefined rate within a specified time frame.

  • Options traders do not have to wait until the expiration date of a vanilla option to "close."

  • Individuals or entities typically utilize it as a hedging strategy.

  • Leveraging is possible for options trading, allowing investors to profit or lose with more significant capital.

  • A European-style option must be in the money on the expiration date to be exercised. An American-style option can be exercised if it is in the capital on or before the expiration date.

  • Exotic alternatives are available, such as barrier options, Asian, and digital options.

Frequently Asked Questions (FAQs): Vanilla option

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Researched and authored by Ka Chun CHIU | LinkedIn

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