Terms

Vanilla Option Definition Types of Option Features and Example

Vanilla Option Definition Types of Option Features and Example

Vanilla Option: Definition, Types, Features, and Example

Vanilla Option

A vanilla option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a given timeframe. It is a call option or put option without special or unusual features. These options are standardized if traded on an exchange like the Chicago Board Options Exchange.

Basics of a Vanilla Option

Vanilla options are used by individuals, companies, and institutional investors to hedge exposure in an asset or speculate on the price movement of a financial instrument.

If a vanilla option is not suitable, exotic options (barrier options, Asian options, and digital options) offer more customization. Exotic options have complex features and are generally traded over the counter. They can be combined into complex structures to reduce costs or increase leverage.

Calls and Puts

There are two types of vanilla options: calls and puts. A call option gives the holder the right to buy the underlying instrument at the strike price, while a put option gives the holder the right to sell the instrument at the strike price. The seller of the option is called the writer. Shorting or writing an option creates an obligation to buy or sell the instrument if the option is exercised.

Calls and puts have an expiry date, which limits the time the underlying asset has to move.

For example, stock XYZ may be trading at $30. A call option with a one-month expiry has a strike price of $31. The premium (option cost) is $0.35, and each option contract controls 100 shares, making the total cost $35.

READ MORE  Market-on-Open Order MOO Definitiion When to Use It

If the price of XYZ stock moves above $31, the option is in the money. However, the underlying asset needs to move above $31.35 for the buyer to see a profit. The maximum loss for the option buyer is the amount paid for the option, while the profit potential is unlimited and depends on how far the underlying moves above the strike price.

The option writer collects $35 for writing the option. If the price of XYZ stock stays below $31, the option is out of the money, and the writer keeps the premium. However, if the price rises above $31, the writer has an obligation to sell the stock to the buyer at $31. For example, if the stock rises to $33, the writer incurs a loss of $165 ($35 – $31) x 100 = $200, minus the $35 premium.

Vanilla Option Features

Every option has a strike price. If the strike price is better than the price in the underlying market at maturity, the option is deemed "in the money" and can be exercised. European style options require in-the-money status on the expiration date, while American style options can be exercised on or before the expiration date.

The premium is the price paid to own the option and is based on the strike price’s proximity to the underlying price (in the money, out of the money, or at the money), the volatility of the underlying asset, and the time until expiration. Higher volatility and longer maturity increase the premium.

An option gains intrinsic value as the underlying surpasses the strike price—above for a call and below for a put.

READ MORE  Marginal Analysis in Business and Microeconomics With Examples

Option traders don’t need to wait until expiry to close out a trade or exercise the option. They can take an offsetting position at any time to realize their profit or loss.

Key Takeaways

Vanilla options are financial instruments that enable the purchase or sale of an underlying asset at a predetermined strike price within a defined timeframe. They consist of call and put options, allowing their owners the right to buy or sell an underlying asset. Vanilla options can be combined with exotic and binary options to create custom outcomes.

Exotic and Binary Options

Exotic options have conditions or calculations attached to their execution. Barrier options include a level that, if reached, causes the option to begin or cease existence. Digital options pay the owner if the underlying is above or below a specific price level. An Asian option’s payoff depends on the average traded price of the underlying instrument during the option’s life.

Binary options, which can be combined with vanilla options, have limited outcomes, restricting the possible results and payouts. They are commonly used to speculate on asset price movements. One possible combination would involve the purchase of a call/put vanilla option and a binary option in the opposite direction of the former.

Leave a Reply

Your email address will not be published. Required fields are marked *