Vanilla options (or plain vanilla options) give traders the right to buy or sell forex and other assets at a predetermined price in the future. This article covers definitions and types, including European style options, plus the strategies used to execute trades. We’ll also go through an example, before weighing up the pros and cons of trading vanilla options.
What Are Vanilla Options?
A plain vanilla option is a financial instrument that allows holders to buy or sell an underlying asset, at a prearranged price within a given period. The holder owns the right to the transaction but does not necessarily have the obligation to exercise it. The broker acts as the pricer.
The definition of ‘plain vanilla’ comes from the idea that the option has no special features, meaning it is the simplest type of options contract.
Vanilla options are typically used by individual traders, companies, and institutional clients as a hedging tool, which we’ll explore later in this article.
There are different types of vanilla options that you can trade, for example, FX currency options, index options, swap and strip options, plus bond options.
You can find vanilla options trading at many UK-based and worldwide brokers, including IG, LCG, Avatrade, and easyMarkets.
Calls & Puts
Vanilla options consist of two types: call and put options. Call option holders have the right to buy the underlying asset at a predetermined price. This is known as the strike price. Put option holders have the right to sell the underlying asset at the same strike price and time frame.
The time frame is determined by the expiry date, which sets a time limit on the movement of the asset. The seller of the option is known as the writer, who is then obligated to buy or sell the asset, should the holder exercise their right to do so.
Characteristics & Strategies
Vanilla options are characterised by whether they are ‘in the money’ or not. An option is in the money if the strike price is higher than the market price of the underlier at the date of maturity. At this point, the option can be exercised by the owner.
There are several types of trading options that depend on being in the money. European style options need to be in the money at the expiry date in order to be exercised. The point at which an option moves into the money is when it gains intrinsic value. American style options, however, can be exercised if it is in the money on or before the date of maturity.
A premium is also paid by the owner to own the option and is based on the value of the underlier, the time left until expiry, and the volatility of the underlier. If any of these factors increase, the premium will subsequently increase. Options premiums can also be affected by interest rate changes and cash dividends.
Options traders need to consider whether an asset’s current price is reasonable compared to its intrinsic value or future price. Some traders, however, prefer to predict the volatility, rather than the price. This volatility trading strategy assumes that more volatile assets have an increased chance of being in the money. This is why vanilla options are often quoted in terms of implied volatility.
Option Styles & Combinations
Vanilla options can also be combined with other types of options, which can create tailored outcomes. Exotic options, for example, are based on certain conditions that need to be met prior to execution and settlement. Exotic options are generally traded over the counter (OTC).
Binary options are an example of exotic options. They are characterised by only two possible outcomes which can be used to speculate on price movements. Because the payoff is restricted in this scenario, traders often combine binary options with vanilla options.
Other non-vanilla (exotic) options include:
- Barrier options – a limit price is set and determines whether an option can be exercised
- Basket options – an option based on the weighted average of several underlying assets
- Spread options – the underlying asset is a price spread, rather than a single price
We’ve looked at what it means, but what does a plain vanilla options trade look like?
Stock ABC is currently trading at $15. A call option that expires in one week has a strike price of $16, and a cost (premium) of $0.18. Each option consists of 100 shares, therefore the cost of buying one would be $0.18 x 100 = $18.
Stock ABC will need to move above $16 to be in the money, but it will then need to move above $16.18 in order for the buyer to profit. If the value of stock ABC remains below $16, the writer keeps the premium. If the price rises above $16, the writer is obligated to sell the stock to the buyer at $16, even if it rises to $18.
You can find the relevant calculators and pricing valuation formulas within the trading platform of your chosen broker.
Pros & Cons Of Trading Vanilla Options
Reasons to trade vanilla options include:
- Unique strategies can be used (volatility, time decay, etc)
- Maximum loss is predetermined, meaning less risk
- Lots of learning resources, including PDFs
- Can be tailored to the needs of the buyer
- Multiple risk measures, such as delta
- Can be combined with other options
- Good for portfolio diversification
- Leveraged trading opportunities
Disadvantages of trading with vanilla options include:
- Non-refundable premium upon purchase of an option
- Often requires higher capital than other trading instruments
- Total transaction cost could be more expensive than the forward contract
- Price movements in underlying exchange rates can reduce the value of the option at expiry
Vanilla options are a relatively low-risk financial instrument that can be executed using a variety of trading strategies. This article has covered definitions, explained the different types of vanilla options, plus their benefits and drawbacks. Before deciding whether trading with vanilla options is right for you, you may want to consider alternative options instruments.
What are vanilla options?
Vanilla options are a hedging strategy used by traders, where holders can buy or sell an underlying asset at a predetermined price in the future. Vanilla options consist of call (the right to buy) and put (the right to sell) options.
What is the difference: binary options vs. vanilla options?
Binary options are a simple way to trade price fluctuations in a short period of time. The ‘all or nothing’ approach means there is more certainty around the risks of the trade. Vanilla options, on the other hand, offer a longer period of time and greater flexibility to profit from market dynamics.
Where can I trade vanilla options?
There are plenty of FX brokers who offer options trading, including IG, eToro, Avatrade and easyMarkets.
What assets can I trade with vanilla options?
You can trade a variety of assets with vanilla options, including foreign exchange, stocks, bonds, and commodities.
Are vanilla options good for beginners?
Whilst vanilla options are fairly straightforward, they can be complex for anyone who hasn’t traded before. Beginners should always ensure they fully understand the risks involved with leveraged trading.