What is a Vanilla Option?
The term “vanilla option” refers to a type of financial instrument that enables its holders to either buy or sell an underlier, which is an underlying asset, at a predetermined rate within a given time limit. The holder owns the right to sale or purchase of the underlying asset, without necessarily possessing the obligation to do the same.
- The term “vanilla option” refers to a type of financial instrument that enables its holders to either buy or sell an underlier, which is an underlying asset, at a predetermined rate within a given time limit.
- In case of a vanilla option, options traders need not necessarily wait until the date of maturity to “close.”
- It is usually used as a hedging device by an individual or an entity.
What are Options?
Vanilla options fall under the category of derivative financial instruments known as call or put options. Call options give their holder an exclusive right to buy the underlier at a given price on a predetermined date. Conversely, a put option enables its holder to sell said asset under the same conditions: a predetermined date and price. The previously determined price is known as the strike price, and the date is known as the expiry date.
The expiry date puts a time constraint on the movement, or change in ownership, of the asset. The individual or entity that sells the option is known as the writer, and while the holder is under no obligation to execute the sale, the writer is obligated to perform the contract should the holder choose to exercise their right to sell or buy.
Options come in several types. For example, a European style option is one that requires that on the date of expiry, the option must be “in the money” in order to be exercised by the holder. Being “in the money” means that the strike price is higher than the market price of the asset on the date of maturity or expiration date.
The moment an option moves into the money, or when the value of the underlying asset crosses the strike price, is precisely when intrinsic value gets created in the instrument. On the other hand, one can exercise an American style option if it is “in the money” any time up to the date of maturity.
For example, consider Stock X, currently trading at $30. A call option with a strike price of $35, an expiration date within a month, and a premium of $0.50. Every option comprises 100 shares, which means that the cost of buying one option is $0.50 x 100 shares (or $50).
If the price of the share on the expiration date is $35, it is considered to be in the money. However, a premium needs to be deducted in order for the holder to gain a profit. It means that only after the price surpasses $35.50 will exercising the call option profitable for the holder.
Features of Vanilla Options
- A vanilla option is an instrument with no distinguishing or unique characteristics. Usually, if they are traded on exchanges such as the Chicago Board Options Exchange (CBOE), they are standardized.
- In case of a vanilla option, options traders neither need necessarily wait until the date of maturity to “close” nor it is deemed compulsory for them to exercise the option.
- The premium, in such a case, is based on the level of similarity between three basic factors: (1) the price of the underlying asset, (2) the time left until the date of maturity, and (3) the price volatility associated with the underlying asset. A premium is the price paid by the owner to own the option. A higher degree of price volatility leads to a higher premium. Similarly, a longer time period left until the date of maturity increases the premium.
- A vanilla option is usually used as a hedging device by an individual or an entity. Hedging is a technique that is expected to decrease the overall risk exposure to a particular asset. Financial institutions and traders may also use them to speculate the expected price movements of a given financial instrument
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