Vanilla Strategy

What Is a Vanilla Strategy?

Whenever an investor aims to do the simplest of trades, which involve buying the options at a lower price and selling it at a higher price in the future, it is referred to as Vanilla Strategy.

A vanilla option is a straightforward call or puts option with no additional features or expiration dates. It refers to something easy to use and intuitive.

It grants the holder the right, but not the obligation, to purchase or sell an instrument at a certain price in exchange for a premium for a set period of time. The premium is determined by a number of criteria, including the underlying volatility, the option's maturity, and the strike price's proximity to the forward price.

It is a straightforward method for making investing decisions. However, since they take a back-to-basics approach to investing, vanilla methods can also be considered conservative.

It's a method of investing that's solid, consistent, conservative, and adheres to well-known financial concepts. Investors who take this technique are rewarded as well. 

An individual could, for example, set aside money each year to fund a child's college tuition or use automatic wage deductions to fund a retirement account plan. Vanilla Bonds are the most basic sort of bonds, with a predetermined maturity and a fixed coupon payment at predetermined intervals. 

Furthermore, the bond's face value is predetermined, and the investor receives the bond at that amount on the bond's maturity date. 

Individuals can also take a disciplined approach to prepay their mortgage by allocating a few extra monthly dollars to the loan's principal. Because these are fairly basic ways for an individual to invest their money, all these approaches would be labeled vanilla strategies.

Similarly, organizations can flourish by following tried-and-true tactics like concentrating business lines in sectors with a distinct competitive edge. On the other hand, a vanilla strategy in business must allow for some innovation because a competitive advantage for numerous products and services might erode with time.

It's a mix of the four most common vanilla options (short call, long call, short put, long put) with different strike prices, expiration dates, and notional.

Anyone can only price a specified vanilla strategy on the Single Option page. They must manually design it out of individual options to price it on the Portfolio page.

These vanillas are greatly preferred by investors just beginning their investment journey. This selection is due to the ease of concept, understanding, and complete negligence of any complexity.

These are the most basic option securities and are often traded on exchanges after standardization. 

How does Vanilla Strategies work?

Sticking to tried-and-true tactics like passive investing is a systematic way for investors to achieve this. In this case, the investor buys a representative benchmark and holds it for a long time.

A firm can use the same rationale to implement tried-and-true techniques to succeed. They could, for example, concentrate their business line on an area with a distinct competitive edge. 

Vanilla's business tactics include Concentrating resources solely in areas with a significant competitive advantage.

Using debt finance to fund expansion but only at low levels and avoiding reliance on a single product or client.

However, in such circumstances, it is equally critical to guarantee room for innovation. Competitive advantages tend to erode over time as demand for the product or service grows, input prices fall, and so on.

Similar to a heavily leveraged tech start-up, a straightforward, cautious strategy for the business may not capture the financial media's attention. Still, investors will eventually appreciate the robust balance sheet these companies utilizing vanilla techniques typically have.

Vanilla business techniques include:

• Concentrating resources where the competitive advantage is greatest.
• Employing relatively little debt to support growth.
• Avoiding overdependence on a single client or product.

The simplicity of vanilla methods does not detract from their effectiveness; they are not as glamorous or forceful as other approaches. However, implementing and sticking to a standard method over time might be tough. 

When it comes to investment techniques, any number of short-term plans can often outperform a vanilla strategy. In adverse markets, however, it will typically underperform more aggressive methods over the long term.

Following the Global Financial Crisis of 2008, vanilla techniques became increasingly popular. In addition, the risky mortgages in the US housing market contributed to the global financial sector. 

As a result, officials advocated for more rules on investments in unconventional instruments and incentives for traditional investing strategies. It implies that lenders would be required to offer risk-free standardized mortgages.

Examples Of Vanilla Strategy

Here are a few examples that can help one to understand the concept better:

Example #1

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 200 shares of a stock with a current price of $50 per share. You purchase a put option at a premium of $2 per share with a strike price of $50 that expires in two months. So, you paid $400 for a premium of 200 shares.

The stock price lowers to $36 per share in a month. Because your strike price lets you sell the shares for $50 rather than $36, now is a good opportunity to exercise that premium.

You wouldn't make any money because you're essentially selling the stocks for what you paid for them ($50), and you might even lose money (that $2 per share premium). Still, the alternative is that you'd lose even more money if you waited and the price dropped even more or if you didn't have the option.

Example #2

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

Let's say you're interested in a stock now priced at $106, and you can buy a call option on it within one month to purchase it at $110 per share. This is a stock option for 200 shares.

This option has a $0.3 premium per share. As a result, the premium would be $30. You are under no obligation to buy the shares. You can earn if the stock trades for more than $110.3 (option price plus premium).

Let's imagine the stock is trading at $118 in two weeks. It's "in the money," as they say. It's a good moment to execute your option because you can get $7.70 per share and $770 for 200 shares. You can either sell the shares immediately to cash in on the profit or keep them to see if the stock price rises further.

Characteristics of vanilla strategy

It is no alien regarding the involvement of risk and volatility in its trade. However, it comes with its characteristic features, which are unique to it. 

Here are a few of the commonly recognizable characteristics of the strategy:

1. Premiums

Whether you want a vanilla call or a vanilla put, you'll have to pay a premium on top of what you'd pay for the stock if you bought it with a call. Because the premium isn't refundable, you'll lose the money you spent on it if you don't use the option.

The premium amount can be affected positively or negatively by a change in the interest rate or cash dividends.

2. Volatile

The price of an option is determined by its volatility. The higher the option's volatility, the higher the premium because there is a greater chance of profit (as well as the risk of loss).

Using an options trading straddle, in which you buy both a put and a call option simultaneously, is one technique to limit volatility.

3. Risk Proportion

Options, like most other types of investments, include some risk. For example, if the market price of a stock is lower than the price of a call option, the option is worthless. Furthermore, if a stock's market price is greater, the put option will not provide a higher return on investment.

Conversely, a vanilla option may be less hazardous than buying a stock outright because you're only guaranteed to spend the premium.

4. Option Moneyness

If the striking price of an option is higher than the market price of the underlier at the end of the term, the option is already in the money. Therefore, the owner has the discretion to exercise it at this juncture.

When an option swings into the money, it is said to have acquired intrinsic value.

Advantages and Disadvantages Of Vanilla Strategies

In finance, most aggressive short-term investing strategies tend to outperform vanilla strategies. Unfortunately, this feature makes it difficult for investors to stick to tried-and-true tactics, especially since they often invest for the long term.

It may not suit every investor's income or return expectations, which is an additional negative. Aggressive strategies, on the other hand, tend to underperform vanilla techniques in difficult markets.

Below mentioned are a few of the advantages of trading using vanilla strategies:

• Although the basic concept of the strategy is quite simple and can be easily understood by anyone and everyone, it does provide uniqueness to its users in the form of volatility and time decay.

• Most of the time, loss pertaining to a particular commodity can be easily determined in advance; hence, it has a lesser amount of risk attached to it.

• For first-time investors or traders, it is always advised to begin with the vanilla strategy because of its simplicity and abundance of learning material available both online and offline.

• This simple strategy can be easily molded according to the needs of the buyer, i.e., they can make simple changes in the rules to meet their demands.

• A lot of risk measures can be combined. A common example is Delta.

• After an investor has spent enough time on the market and become acquitted to its nature, they can make slow shifts from the vanilla strategy to the other strategies. The first step of this shift could be using a combination of these strategies, which is very easily possible in the vanilla strategy.

• The vanilla strategy should be the investor's go-to option if they aim to diversify their portfolio.

• There are a lot of leveraged trading opportunities available in this simple strategy.

Despite all these benefits, the vanilla strategy suffers from some disadvantages as well, which have been discussed below:

• Once an option has been purchased, the premium on it is non-refundable. Thus, enough thought must be given before making any purchase, and decisions must not be made in haste.

• It has been witnessed that these options often require a capital amount that is higher when compared to other trading instruments.

• When compared to forwarding contracts, these often have a higher transaction cost and hence may make a hole in the pockets of the investor.

• The movements in the prices of the underlying exchanges can aid in reducing the value of the option at the time of expiry.

Different types of vanilla options

There are two types of vanilla options available to any investor. They can choose from these options according to their own wishes. There is no compulsion on investors to choose a particular instrument, they have the opportunity to choose the option which they think or feel would be an option for them. 

The two vanilla options are as follows:

1. Call Option
2. Put Option

They have been discussed in detail below for a better understanding of the concept:

1. Call Option

A vanilla call option allows an investor to purchase an asset at a specific price within a specified time frame. A call option is similar to a down payment in that the investor pays the premium in order to eventually buy the shares at a lower price and profit.

An investor, on the other hand, can pay the premium yet never use the option. If they decide not to exercise it, they will either lose the premium they paid or have the option to sell the call option before it expires.

2. Put Option

A put option, on the other hand, permits an investor to sell an asset at a certain price within a specified time frame. If a stock's value plummets during the time that the option is valid, the investor can still sell it for the put price and avoid losing as much money. 

However, if the stock's value rises above the market put price, the vanilla options are useless because the investor may sell the stock at the market price and make a larger profit.

The premium is established by that of the market at the same time of the trade, including both options trading scenarios. The rate of something like the underlying instrument at expiration will determine the gains and losses based on the strike price.

Researched and authored by Kanishka Bajoria | LinkedIn 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Average Collection Period
• Demand for Money
• Price Bubble
• Transfer Pricing
• Vertical Equity