Vanilla options, commonly referred to as vanillas, are a kind of financial derivative that presents multiple simple trading opportunities and a world of possibilities for traders. This comprehensive guide will delve deeper into the world of vanilla options, answering what they are and how they work.
An overview of vanilla options
Vanilla options are a type of options contract. These financial instruments give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (known as the strike price) within a specific timeframe. When you trade vanilla options with Deriv, you’ll get a payout if the contract is successful.
To fully grasp how vanilla options work, it’s essential to understand key terms and concepts, including the option premium, expiration date, and the options’ intrinsic and time value.
| Duration/End time: The duration of a vanilla option is the amount of time that the option remains in force. The ‘end time’ is also known as the expiration date or expiry date. After the expiration date, the option can no longer be exercised. |
| Stake amount: When you purchase a vanilla option, you pay a fee known as the premium or stake amount to the option seller. This premium serves as the cost of obtaining the rights that the option contract provides. |
| Call/Put: A call option gives the buyer the right, but not the obligation, to buy the underlying asset at the strike price on or before the expiration date. A put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price on or before the expiration date. With Deriv, these contracts are settled in payout instead of the actual asset. |
| Intrinsic and time value: The price of a vanilla option hinges on its intrinsic value and time value. The intrinsic value refers to the difference between the underlying asset’s current price and the strike price. Meanwhile, the time value is based on the remaining time until the option’s expiration. |
| Strike price: The strike price, or exercise price, is a fundamental concept in options trading. It represents the predetermined price at which an option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. The strike price is set when the option contract is formed and plays a crucial role in determining the option’s potential payout. |
Call and put options: The two types of vanilla options
Vanilla options primarily come in two forms: call options and put options.
| Call options | Put options |
|---|---|
| A call option allows the buyer the right to buy the underlying asset at the strike price before the option’s expiration date. | A put option provides the buyer with the right to sell the underlying asset at the strike price before the option’s expiration. |
| Traders generally opt for call options when they anticipate an increase in the asset’s price, allowing them to lock in a lower purchase price. | Traders usually prefer put options when they expect a decrease in the asset’s price, ensuring the ability to sell at a higher price even if market prices fall. |
How do vanilla options work?
To buy a vanilla option, the trader pays a premium (also known as buy price or stake amount) to the seller. The premium is determined by several factors, including the underlying asset’s current price, the strike price, the expiration date, and the underlying asset’s volatility.
If the holder of a call option decides to exercise the option, they must pay the strike price to the seller and will receive the underlying asset or a payout as done on Deriv if the market moves in their favour. If the holder of a put option decides to exercise the option, they must sell the underlying asset to the seller at the strike price.
Payoff structure of vanilla options
The payoff structure of a vanilla option depends on whether it is a call or put option and whether it is exercised or expires unexercised.
Call and put option payoff
If you decide to exercise your call option and it moves in your favour by the end of the selected duration, you’ll receive the difference between the strike price and the underlying asset’s price. However, if the underlying asset price is below the strike price, the call option will expire unexercised, and you’ll only lose the premium (initial stake).
Similarly, if the underlying asset price exceeds the strike price, the put option will expire unexercised, and you’ll only lose the premium (initial stake).
Key points to remember
Vanilla options provide a flexible financial instrument that allows buyers to secure the right to buy or sell the underlying asset(s) at a pre-determined price within a specific time frame. They come in two types: call options for when prices are expected to rise and put options for when prices are predicted to fall. On Deriv, these contracts have payouts rather than the actual asset.
It’s crucial to remember that trading in vanilla options carries significant risk. Therefore, it’s advisable only to trade them if you clearly understand the risks involved and have a well-defined risk management strategy.
Practise your trading strategy with a demo account on Deriv. It comes with virtual funds, so you can practise trading vanilla options risk-free on volatility indices. Build confidence and refine your technique before entering the real market.
Disclaimer:
Vanilla options are not available to clients residing in the EU.
The information contained within this blog article is for educational purposes only and is not intended as financial or investment advice.