What Is Vanilla Option?
A vanilla option is a type of financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period without any complex terms. It aims to provide investors with a flexible tool for managing risks or speculating price movements.
The term “vanilla” describes options with a standard set of features, terms, and conditions, which investors commonly trade. For example, these standard options have a fixed expiration date, a predetermined strike price, and no complex features. In contrast, more complex options may have customized terms, such as exotic payoffs or multiple underlying assets, making them harder to trade.
Table Of Contents
- A vanilla option is a basic type of options contract that allows the buyer to buy or sell an underlying asset at a predetermined price on or before a specific expiration date without any additional terms or conditions.
- They are commonly used to gain insights into security trading and future security prices to earn profits through buying and selling securities.
- There are two types of vanilla options: call options, which give the buyer the right to buy the underlying asset, and put options, which give the buyer the right to sell the underlying asset.
Vanilla Option Explained
Vanilla options are one of the most well-known and commonly traded options. They are the simplest and most basic options without exotic characteristics. As a result, they are widely used by investors and traders to hedge against or speculate on the future price movements of underlying assets such as stocks, bonds, currencies, and commodities.
There are two types of vanilla options: call options and put options. A call option gives the holder the right to buy the underlying asset at the strike price, while a put option gives the holder the right to sell the underlying asset at the strike price. When an investor buys an option, they pay an option premium to the option seller. The premium is the cost of the option and depends on factors such as the volatility of the underlying asset, the time until expiration, and the strike price.
Vanilla Option Strategies
Vanilla options are trading strategies that use standard or basic options contracts, or plain vanilla options, to achieve a specific investment objective. Some common strategies include long call, long put, covered call, protective put, collar option, long straddle, and strangle. However, many other options are available to traders depending on their risk tolerance and market outlook.
Let us review a few vanilla options examples to understand the topic’s technicality.
A trader holds a call option on a security named FGH, with a strike price of $100 and a vanilla option maturity date of 31st July 2022. This means the trader has the right, but not the obligation, to buy the FGH security for $100 upon its maturity date.
If on 31st July 2022, the price of the FGH security is lower than the strike price of $100, the trader will not exercise their option to buy. However, if the FGH security price is higher than the strike price on the maturity date, the trader can purchase the security at the strike price of $100 and sell it in the market for a profit.
It’s important to note that the trader can also sell the call option to another investor before its expiration date. The call option price will depend on the current market price of FGH, the remaining time until maturity, and the strike price. The trader can profit if the market price of FGH increases, leading to an increase in the call option price.
An example of vanilla options associated with a long put strategy is when an investor expects a company’s stock price to fall soon. In this case, the investor can purchase a put option on the stock with a strike price below the current market price.
For example, an investor owns 100 shares of ABC Corp., trading at $50 per share, and expects the stock price to decline. As a result, the investor can purchase a put option with a strike price of $45 per share for a premium of $2 per share. This gives the investor the right to sell the stock at $45 per share, regardless of its market value.
If the stock price falls below $45 per share, the investor can exercise the option and sell the shares at the higher strike price, resulting in a profit. Conversely, if the stock price remains above $45 per share, the investor can simply let the option expire, losing only the premium paid.
This long-put strategy is a way for investors to protect themselves against potential losses in the value of their stock holdings while limiting their downside risk.
Frequently Asked Questions (FAQs)
A vanilla options broker is a financial intermediary that allows traders to buy and sell plain vanilla options by providing access to the options market and a trading platform. These brokers can be traditional or online, with online brokers offering lower trading fees and additional resources to support informed trading decisions.
A vanilla option is a standardized contract with no special features or complex terms. In contrast, a European option is a vanilla option that can only be exercised on the expiration date. The key difference is that a European option has a fixed expiration date, while other vanilla options can be exercised any time before expiration.
A vanilla option is a standardized contract with no special features or complex terms. In contrast, an exotic option is a non-standard contract with complex terms and features that may be tailored to meet specific needs or objectives. The key difference is that vanilla options are simple, standardized contracts traded on exchanges, while exotic options are customized contracts traded over the counter (OTC) with unique features and conditions.
This article has been a guide to what is Vanilla Option. Here, we explain the topic in detail with its various strategies and examples. You may also find some useful articles here –