Vanilla Options refers to a financial instrument that allows the holder the right, but not the obligation to buy or sell the underlying asset at a predetermined price. The vanilla option consists of a call option and a put option. A vanilla option can also be combined with an exotic option to create custom outcomes.
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What are Vanilla Options?
A derivative is a form of asset which is dependent on the underlying asset and its movements. There are various forms of derivatives in the financial market like futures, forwards, options, and swaps.
A plain vanilla option is a normal option derivative which is an exchange-traded derivative. A vanilla option consists of a Call Option and a Put Option that has no specific or unusual exotic features. These options are standardized and free from counterparty risk if it is being traded-in exchanges such as NSE (National Stock Exchange), BSE (Bombay Stock Exchange), CBOE (Chicago Board OF Exchange), etc. Vanilla options are used by investors, companies, institutional investors, etc to hedge their portfolios or to speculate the movement in the price of the underlying asset.
How does a Vanilla Option Work?
The vanilla option consists of the Call option & Put Option:
In a call option, two investors are holding a position in an underlying asset. One holds a long call option and the other investor shorts the call. The option holder is in a Long position means he has the right to buy the asset at maturity but not the obligation to buy it. The short position investor is the one who sells the asset at maturity he is obligated to sell the asset as he is in a short position.
The long position investor buys the call option by paying a certain amount as a call premium at a predefined strike price at the date of maturity. The short position holder does not have to pay the premium as he is obligated to sell the asset. If the call is ITM (in-the-money) on the date of maturity the call option holder will buy the asset and earn a profit. If it is OTM (out-of-the-money), or ATM (at-the-money) the option holder won’t perform the trade and face a maximum loss of the premium paid
In a call option, the option holder thinks the price will go up in the future and hence takes a long position to buy the asset and the short position thinks the underlying asset price will go down
In a put option, two investors are holding the position in an underlying asset. One holds the long put option and the other investor holds the short put option. The option holder is in a long position means he has the right to sell the asset at maturity but is not obligated to sell it. The short position investor is the one who is obligated to buy the asset as he is in a short position.
The long position investor buys the put option by paying a certain amount as a put premium at a prespecified strike price and maturity. The short position holder does not have to pay the premium as he is obligated to buy the underlying asset. If the put is ITM (in-the-money) the put option holder will sell the underlying asset and earn a profit. If it is OTM (out-of-the-money) or ATM (at-the-money) the option holder won’t carry the last and face a maximum loss of the premium paid.
In a put option the option older thinks the price will go down in the future, therefore, takes a long position input and the short position holder thinks the price will go up in the future.
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Stock XYZ may be trading at Rs.30. A call option that expires in one month has a strike-price of Rs.31. the cost of this option, called the premium is Rs. 0.35. each options contract controls 100 shares, so buying one option costs Rs.0.35 x 100 shares, or Rs. 3
If the price of XYZ stock moves above Rs. 31, that option is ITM (in-the-money). But the underlying asset needs to move above Rs. 31.35 for the buyer to start seeing a profit on the trade. The most option buyer can lose is the amount they paid for the option i.e premium. The profit potential is unlimited and depends on how far the underlying asset moves above the strike price.
The option writer collects Rs. 35 (Rs.0.35 x 100 shares) for writing the option. If the price of XYZ stock stays below Rs.31, the option is said to be OTM (out-of-the-money) and the writer keeps the premium. However, if the price rise above Rs.31, the option writer should sell the stock to the option buyer at Rs.31. For example, if the stock rises to Rs.33, this would represent a loss of Rs.165, or (Rs.33 – Rs. 31) x 100 = 200, then subtract the Rs.35 premium already collected for a loss of Rs. 165.
Advantages & Disadvantages of Vanilla Options:
- Vanilla options protect against adverse moments in the exchange rate of the currency pair during the term of the contract.
- Vanilla options are not subjected to SCOL’s margin call policy, as bought vanilla options cannot carry a negative mark-to-market value.
- As the buyer of the option can select the strike, expiry, and notional amount, vanilla options a=can be tailored to the exact needs of the buyer.
- The buyer of the vanilla option is under no obligation to exchange currencies and is, therefore, able to participates in all favorable exchange rate movements.
- Non-refundable premium upon purchase of an option.
- Often requires higher capital than other trading instruments.
- Price movements in underlying exchange rates can reduce the value of the option at expiry.
- Total transaction cost could be more expensive than the forward contract.
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Vanilla options are relatively low-risk financial instruments that can be executed using various trading strategies. Before deciding whether trading with vanilla options is right for you, you may want to consider alternative option instruments and derivative instruments.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.