Vanilla options: Meaning, types, characteristics and importance
Vanilla options are the most basic type of options contract. They offer a clear choice to buy (call) or sell (put) an asset at an agreed price, up to a specific date, without any obligation. In this blog, we'll discuss the essence of vanilla options, their common types, key features, and their role in the derivatives market.
You've probably come across the term 'options'. The idea originated with Thales of Miletus, an ancient Greek thinker. He cleverly acquired rights to olive presses, predicting a rich olive harvest. When the season yielded a large crop, he capitalised on the soaring demand for presses. This move was one of the first known examples of options trading, which later became popular in Amsterdam and London.
By the early 2000s, vanilla options made their debut in India as well. Today, the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) oversee this market and ensure its smooth functioning.
Let’s begin our discussion on vanilla options and explore them in depth.
Understanding vanilla options
Vanilla options, commonly known as 'options', are contracts that allow you to buy or sell an asset at a fixed price within a specific time frame, much like securing today's price for a holiday you'll take in the future. The asset in question is termed the 'underlying asset', which can be stocks, commodities, currencies, or indices.
Example of vanilla options trading
Let's consider ABC stock, priced at INR 1,000. Believing it will rise in the next three months, you pay a premium for the right to buy it at INR 1,000. If its price climbs to INR 1,500, you can still purchase it for INR 1,000 due to your option. However, if it drops, you're not obligated to buy, only losing the premium.
Key terms from the example:
- Underlying asset: The item in the option contract, in this case, ABC stock.
- Strike price: The agreed price for the asset. Here, it's INR 1,000.
- Premium: The fee for securing the option.
- Expiration date: The option's end date; post this, the option can't be exercised.
Types of vanilla options
Vanilla options are primarily of two types:
- Call options: With a call option, you have the right to buy the underlying asset at a specified price before a certain date. You'd opt for this when you expect the asset's price to go up, allowing you to lock in a purchase at a lower price.
- Put options: Conversely, a put option lets you sell the underlying asset at an agreed-upon price before the expiry date. You'd choose this if you believe the asset's price will fall, ensuring you can sell at a higher price even if the market dips.
On 8th September 2023, the Nifty 50 was trading at 19,817.95. Based on your research, you decided to buy either a call option or a put option.
For the call option:
Let’s say you bought a call option of the Nifty 50 at 19,817.95, expecting its value would go up. Each unit had a premium of INR 150, so you paid INR 7,500 in total. By the end of the month, on the last Thursday, which is the expiry date for European options, if the Nifty 50 were to hit 20,117.95, you would earn a profit of 300 points for each unit. This would give you a total profit of INR 15,000. After deducting the premium, you would receive a net profit of INR 7,500.
For the put option:
Suppose you bought a put option to sell the Nifty 50 slightly below 19,817.95, thinking it would drop. The premium for each unit was INR 100, costing you INR 5,000 in total. If the Nifty 50 were to decrease to 19,517.95 by the expiry date, you would earn a profit of 300 points for each unit. This would result in a total profit of INR 15,000. After accounting for the premium, your net profit would be INR 10,000.
Unique features of vanilla options
Here are some of the unique features of vanilla options:
Standardised financial contracts:
Vanilla options are traded extensively on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), with uniform contract sizes, terms, and expiration dates.
When you buy a vanilla option, you pay a premium to the seller. This premium is the cost of obtaining the rights that the option provides.
The strike price is the predetermined price at which the option holder can buy (for call options) or sell (for put options) the underlying asset.
Every vanilla option has a set expiration date. For European options, this is the only day the option can be exercised, while American options can exercised any time until the expiry.
Intrinsic and time value
The price of a vanilla option is based on its intrinsic value (the difference between the current price of the underlying asset and the strike price) and its time value (the value based on the time left until expiration).
Profit and loss potential
The profit and loss potential for vanilla options buyers is asymmetric. While the loss is limited to the premium paid, the profit potential is unlimited for call options and substantial for put options.
Wrapping up: Key points to remember
- Vanilla options let you buy or sell assets at a fixed price you agree on beforehand. You have a specific timeframe (called expiration date) to use options.
- There are two types of vanilla options: call options, which you buy if you expect the price to go up, and put options, which you sell if you expect the price to go down.
- Vanilla options are a risky investment, and you should only trade them if you understand the risks involved.
Want to master options trading? Check out these helpful resources to boost your skills and confidence.