What is the vanilla option?

A vanilla option is a financial instrument that allows its holder to purchase or sell an underlying asset at a defined price within a certain period but is not obliged to do so. A vanilla option is a call-or-put option lacking unique characteristics. These options are standardized if traded on an exchange like the Chicago Board Options Exchange.

Basics of a Vanilla Option

Individuals, businesses, and institutional investors utilize vanilla options to speculate on financial instruments’ price movements or hedge their exposure to a particular asset.

Exotic alternatives, such as barrier options, Asian options, and digital options, are more adjustable if a vanilla option isn’t the best match. Exotic options are often traded over the counter and have more intricate characteristics. They might be merged into complex structures to lower the net cost or raise leverage.

Puts and Calls

Vanilla options come in two varieties: puts and calls. The right, not the responsibility, to purchase the underlying asset at the strike price belongs to the call owner. A put’s owner has no legal need to sell the instrument at the strike price, although they are free to do so. The option’s writer is the one who sells it. If you write or short an option, you must purchase the instrument if the option’s owner exercises it.

Both puts and calls have an expiration date. This limits the amount of time that the underlying asset may move.

For instance, the price of stock XYZ may be $30. The striking price of a call option with a one-month expiration date is $31. This option has a $0.35 charge associated with it. Purchasing one option costs $0.35 times 100 shares, or $35, as each option contract owns 100 shares.

The option is in the money if the price of XYZ stock rises over $31. However, for the buyer to start making money on the deal, the underlying asset must rise above $31.35. The option buyer’s maximum loss equals the option’s purchase price. The extent to which the underlying climbs above the strike price determines the potential profit, which is infinite.

For writing the option, the writer receives $35 ($0.35 x 100 shares). The choice is considered out of the money, and the writer retains the premium if the price of XYZ stock remains below $31. However, the option writer must sell the shares to the buyer at $31 if the price increases over $31. If the stock, for instance, climbs to $33, this would indicate a loss of $165, or $35 minus $31 x 100 = $200. Subtract this amount from the $35 premium already received to arrive at a loss of $165.

Features of Vanilla Options

There’s a strike price for each option. The option is considered “in the money,” and the owner may exercise it if the strike price is higher than the price in the underlying market at maturity. A European-style option must be in the money on the expiry day to be exercised. It may be exercised if an American-style vote is in the capital before the expiration day.

The cost of purchasing the option is known as the premium. The premium is determined by the strike’s proximity to the underlying price (in the money, out of the cash, or at the capital), the underlying asset’s volatility, and the remaining time before expiry. The premium rises with longer maturity and more volatility.

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

Options traders are not required to exercise their options or wait until expiration to close a deal. To terminate the options transaction and realize their profit or loss, they might take an offset position at any moment.

Binary and exotic options

To achieve customized results, vanilla choices may be paired with two additional options. Exotic options are the first kind, subject to computations or conditions when executed. Barrier choices, for instance, may have a threshold that, when met, would make the option either nonexistent or present. If the underlying is above or below a predetermined price level, digital options pay the owner. The average traded price of the underlying instrument over the course of the option’s life determines the payment for an Asian option.

Binary options are the second option that may be coupled with regular options. These choices usually have just two potential outcomes, which implies that the rewards are likewise limited. Usually, they are used to predict an asset’s price changes. Buying a call/put vanilla option and a binary option that moves in the opposite direction of the vanilla option would be one way to combine binary and vanilla options.

Conclusion

• Financial products known as vanilla options allow the buying or selling of an underlying asset at a predetermined strike price within a specific window of time.
• Vanilla options consist of call-and-put options, which give owners the choice—but not the responsibility—to purchase or sell an underlying asset.
• Combining vanilla options with binary and exotic options can produce unique results.