Vanilla options (also known as plain vanilla options) provide traders the right to buy or sell currencies and other assets in the future at a set price.
Let’s look at vanilla options, how they work, and why they are important.
What Are Vanilla Options?
A plain vanilla option is a financial instrument that allows holders to buy or sell an underlying asset at a set price over a certain period of time. The holder has the right to the transaction but not necessarily the responsibility to carry it through. The broker is the one who sets the price.
The term ‘plain vanilla’ refers to an option with no unique characteristics, making it the most basic type of options contract. Individual traders, companies, and institutional clients typically use vanilla options as a hedging tool. You can trade various vanilla options, including FX currency, index, swap and strip, and bond option.
Types of Vanilla Options
In vanilla trading, there are two types of options: call and put.
A call option gives the holder the right to buy the underlying asset at a specific price. The strike price is the cost of buying and selling an agreement. Put option holders can sell the underlying asset at the same strike price and for the same time period.
The expiry date establishes a time limit on the asset’s movement, which determines the time frame. The seller is the person who sells the option and is responsible for buying or selling the asset if the holder uses their right to do so.
How Do Vanilla Options Work?
The buyer of a vanilla option chooses the currency pair, expiry date, notional amount, and strike rate. The premium payable by the buyer of the vanilla option will be calculated by Smart Currency Options Limited (SCOL). Unless you choose a deferred premium option, then it is due within two business days.
A deferred premium option is one that is settled after the usual two business days have passed (typically upon expiry of the contract). Please note that not all SCOL clients have access to delayed premium vanilla options. When the vanilla option expires, the buyer can either use their right to transact or let the option expire worthlessly. Here’s how it works in more detail:
- If the current spot rate is less favorable at the expiration date than the strike rate of the option, the buyer will be better off using his right to transact at the strike rate. Customers can use SCOL to trade offsetting FX transactions to close in the money option positions if the underlying exposure, and therefore the need to trade, has ended.
- If the current spot trade is higher than the strike rate of the option at the expiration date, the buyer of the option will be better off allowing the option to expire worthlessly. This is because the spot rate will be a better exchange rate than the strike rate of the option.
Vanilla Option Features
A strike price is a price at which an option is executed. If the strike price is higher than the underlying market price at maturity, the option is considered “in the money,” and the owner can execute it.
In order for a European Style option to be executed, it must be in the money on the expiration date. It can be executed if an American Style option is in the money on or before the expiration date. The premium is the price of the option. The strike price’s closeness determines it to the underlying asset’s price, the underlying asset’s volatility, and the time before expiration.
Bermudan Style option differs from European and American Style options. A Bermudan Style option contract specifies the number of days before expiration on which the trader can execute his option. The execution dates are usually close to the expiration date of the option. In terms of how much flexibility a trader has to execute an option, Bermudan options sit between American and European Style options.
Advantages and Disadvantages of Vanilla Options
Advantages
- Learning resources (including PDFs)
- Tailored to the buyer’s needs
- Less risky
- Can be combined with other options
- Leveraged trading opportunities
Disadvantages
- Non-refundable premium option
- Requires higher capital than other trading options
- The total transaction cost might be more expensive than the contract
- Price movements in underlying exchange rates can reduce the option’s value at expiration.
Takeaways
- Vanilla Options provide traders the right to buy or sell currencies and other assets.
- There are two types of vanilla options: call and put options.
- Call Options give the holder the right to buy the underlying asset at a certain price.
- Put Option holders can sell the underlying asset at the same strike price and at the same time.
- There are three main features of Vanilla Options: European, American, and Bermudan styles.
