What is a 'Vanilla Option'

A vanilla option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset, security or currency at a predetermined price within a given timeframe. A vanilla option is a normal call or put option that has no special or unusual features. It may be for standardized sizes and maturities, and traded on an exchange such as the Chicago Board Options Exchange or tailor-made and traded over the counter.

BREAKING DOWN 'Vanilla Option'

Individuals, companies and institutional investors can take advantage of the versatility of options to design an investment that best meets their need to hedge an exposure or speculate on the price movement of a financial instrument. If a vanilla option is not the right fit, they can explore exotic options such as barrier options, Asian options and digital options. Exotic options have more complex features and are generally traded over the counter; they can be combined into complex structures to reduce the net cost or increase leverage.

Calls and Puts

There are two types of vanilla options: calls and puts. The owner of a call has the right, but not the obligation, to buy the underlying instrument at the strike price; the owner of a put has the right, but not the obligation, to sell the instrument at the strike price. The seller of the option is sometimes referred to as its writer; selling the option creates an obligation to buy or sell the instrument if the option is exercised by its owner.

Features

Every option has a strike price; this can be thought of as its target. If the strike price is better than the price in the market at maturity, the option is deemed "in the money" and can be exercised by its owner. A European style option requires the option be in the money on the expiration date; an American style option can be exercised if it is in the money on or before the expiration date.

The premium is the price paid to own the option. The size of the premium is based on how close the strike is to the current forward market price for the expiration date, the volatility of the market and the option's maturity. Higher volatility and a longer maturity increase the premium.

An option gains intrinsic value as the market price approaches or surpasses the strike price. The owner of the option can sell it prior to expiration for its intrinsic value.

Exotic Options

There are many types of exotic options. Barrier options include a level that, if reached in the market before expiration, cause the option to begin to exist or cease to exist. Digital options pay the owner if a certain price level is hit. An Asian option's payoff depends on the average traded price of the underlying instrument during the life of the option. Options structures combine vanilla and exotic options to create tailor-made outcomes.

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