Vanilla Option

What is a 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. A vanilla option is a call option or put option that has no special or unusual features. Such options are standardized if traded on an exchange such as the Chicago Board Options Exchange. 

Basics of a Vanilla Option

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

If a vanilla option is not the right fit, exotic options such as barrier options, Asian options, and digital options are more customizable. Exotic options have more complex features and are generally traded over the counter. They can be combined into complex structures to reduce the net cost or increase leverage.

Calls and Puts

There are two types of vanilla options: calls and puts. The owner of a call has the right, but not the obligation, to buy the underlying instrument at the strike price. The owner of a put has the right, but not the obligation, to sell the instrument at the strike price. The seller of the option is referred to as its writer. Shorting or writing an option creates an obligation to buy or sell the instrument if the option is exercised by its owner.

Calls and puts both have an expiry date. This puts a time limit on how long the underlying asset has to move.

For example, stock XYZ may be trading at $30. A call option that expires in one month has a strike price or $31. The cost of this option, called the premium, is $0.35. Each option contract controls 100 shares, so buying one option costs $0.35 x 100 shares, or $35.

If the price of XYZ stock moves above $31, that option is in the money. But, the underlying asset needs to move above $31.35 in order for the buyer to start seeing a profit on the trade. The most the option buyer can lose is the amount they paid for the option. The profit potential is unlimited and depends on how far the underlying moves above the strike price.

The option writer collects $35 ($0.35 x 100 shares) for writing the option. If the price of XYZ stock stays below $31, the option is said to be out of the money and the writer keeps the premium. However, if the price rises above $31, the option writer has an obligation to sell that stock to the option buyer at $31. For example, if the stock rises to $33, this would represent a loss of $165, or ($35 – $31) x 100 = $200, then subtract the $35 premium already collected for a loss of $165.

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 by its owner. A European style option requires the option be in the money on the expiration date in order for it to be exercised. An American style option can be exercised if it is in the money on or before the expiration date.

The premium is the price paid to own the option. The premium is based on how close the strike is to the price of the underlying (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 a longer maturity increase the premium.

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

Option traders don't need to wait until expiry to close out an options trade, nor do they need to exercise the option. They can take an offsetting position at any time to close the options trade and realize their profit or loss on the option.

Exotic and Binary Options

Two other types of options can be combined with vanilla options to create tailored outcomes. The first type are exotic options, which have conditions or calculations attached to their execution. For example, barrier options include a level that, if reached, causes the option to begin to exist or cease to exist. 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 life of the option.

The second type of options which can be combined with vanilla options are binary options. The outcome of such options is typically restricted to just two possible results, meaning that the payouts are also restricted. They are typically used to speculate on price movements of an asset. A possible combination between binary and vanilla options would be the purchase of a call/put vanilla option and a binary option in the opposite direction of the former.