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.

RELATED TERMS
  1. Stock Option

    Stock options give the holder the right to buy or sell shares ...
  2. Listed Option

    A listed option is a derivative security traded on a registered ...
  3. Put Option

    A put options gives the owner the right to sell a specified amount ...
  4. Put On A Put

    One of the four types of compound options, this is a put option ...
  5. European Option

    An option that can only be exercised at the end of its life, ...
  6. Forward Start Option

    A forward start option is an exotic option that is purchased ...
Related Articles
  1. Trading

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  2. Trading

    Options Pricing

    Options are valued in a variety of different ways. Learn about how options are priced with this tutorial.
  3. Trading

    A Newbie's Guide to Reading an Options Chain

    Learning to understand the language of options chains will help you become a more effective options trader.
  4. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  5. Trading

    The Basics Of Option Price

    Learn how options are priced, what causes changes in the price, and pitfalls to avoid when trading options.
  6. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  7. Trading

    What Is Option Moneyness?

    In the money, at the money and out of the money define the current profitability of options positions.
  8. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  9. Trading

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
RELATED FAQS
  1. Regular Vs. Exotic Options: What's the Difference?

    Before learning about exotic options, you need a fairly good understanding of regular options. Read Answer >>
  2. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  3. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  4. How is a put option exercised?

    Learn the process, and what happens, when you exercise a put option. Also, read about alternatives to exercising an option. Read Answer >>
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center