Vanilla options are one of the most popular types of options contracts traded in the market today. A vanilla option is a security that gives you the entitlement, but not the duty, to buy or sell a primary asset at a specified price on or before a specified date.
The underlying asset can be anything from a stock or index to a commodity or currency. The key feature of a vanilla option is that it has only two outcomes – either you make a profit, or you incur a loss. There are no other possible outcomes, unlike some other types of options contracts.
Vanilla options are traded over-the-counter (OTC) between two institutional investors, such as banks, or through an exchange. OTC trading allows for more flexibility regarding the contract size and expiration date, but it also comes with more counterparty risk.
When you trade a vanilla option, you are essentially betting on whether the underlying asset price will rise or fall over a specified period. If you believe the price will increase, you will buy a call option. If you believe the price will fall, you will buy a put option.
How to trade vanilla options
Choose your market
The first step in trading vanilla options is choosing the market you want to trade in. For example, if you are interested in trading options on the FTSE 100 index, you will need to find a broker that offers this market.
Choose your expiration date
The expiration date is when the option contract expires and becomes void. When choosing an expiration date, you need to consider factors such as the time frame of your analysis and your overall investment objectives.
Choose your strike price
The strike price is the price of the underlying asset when it is bought or sold if the option is exercised. If you are buying a call option, you will need to choose a strike price below the current market price. If you are buying a put option, you will need to choose a strike price above the current market price.
Choose your contract size
The contract size is the number of options contracts that you are buying. Most brokers will allow you to trade in lots of 1,000 options.
Execute your trade
Once you have chosen your market, expiration date, strike price and contract size, you can execute your trade by placing an order with your broker.
Risks of vanilla options
Volatility measures the amount by which an asset’s price fluctuates. It is one of the most important factors to consider when trading vanilla options, as it can significantly impact the price of the option.
Time decay risk
Time decay is the rate at which the value of an option contract declines as it approaches its expiration date. As the expiration date gets closer, there is less time for the underlying asset’s price to move in the desired direction.
Liquidity risk is the risk that you will not be able to find a buyer for your option contract when you want to sell it. It can occur if there is insufficient trading activity in the market for the particular option contract you are trying to sell.
Advantages of vanilla options
Vanilla options offer a high degree of flexibility, as you can customise them to suit your specific investment objectives. For example, you can choose the expiration date and strike price that best meets your needs.
Another advantage of vanilla options is that they come with limited risk because you only stand to lose the premium you paid for the options contract. Your loss is capped at this amount, no matter how far the underlying asset’s price moves against you.
Potentially high returns
Vanilla options also offer the potential for high returns. If the underlying asset’s price moves in the direction you predicted, you could make a profit of up to 100% profit.
Access to global markets
When you trade vanilla options, you can access a wide range of global markets. It allows you to trade on different economic events and take advantage of market opportunities as they arise.