What it means
The name borrows from ice cream, where vanilla is the plain, standard flavour. A vanilla call gives the holder the right to buy an asset at the strike price, which is the fixed price agreed in the contract, and a vanilla put gives the right to sell at that price.
The holder pays a premium up front for the right. If the market moves in their favour, they exercise or sell the option for a gain, and if it does not, they let it expire and lose only the premium.
Vanilla options come in two main styles. A European option can be exercised only on the expiry date, while an American option can be exercised at any time up to expiry, and most listed share options in the US are American style.
Companies use vanilla options to manage risk as well as to speculate. An importer might buy a currency call option to cap the cost of a future payment, and an investor might buy a put to protect a share holding against a fall.
Exotic options, by contrast, include features such as barriers that switch the option on or off, payoffs based on an average price, or choices made later. These are harder to price and often traded over the counter, so vanilla options remain the benchmark for pricing models and market data.
The nuance is that the right is limited in time. Options lose value as expiry approaches, which is called time decay, and a buyer can be right about the direction of the market but still lose money if the move comes too late or is too small.
In practice
Real-world examples.
Example
A fund manager holding 10,000 shares buys put options with a strike price just below the current price. If the market falls sharply, the puts rise in value and offset the losses on the shares. The cost of protection is the premium paid.
Example
A US importer expects to pay 5 million euros in three months and buys a vanilla call option on the euro. If the euro strengthens, the option lets the importer buy at the strike price. If it weakens, the importer lets the option lapse and buys at the better market rate.
Example
A trader expects a technology company to rise after its results and buys call options rather than shares. The options cost $2,000 in total, while the shares would cost $50,000. The trader's maximum loss is limited to the $2,000 premium.
Formula
Calculation
Call payoff at expiry = Greater of (Share price - Strike price) and 0
Put payoff at expiry = Greater of (Strike price - Share price) and 0
Net profit = Payoff - Premium paid
An investor buys one call option contract, which covers 100 shares, with a strike price of $50 for a premium of $3 per share. At expiry the share price is $58. The payoff is 58 - 50 = $8 per share, so the net profit is 8 - 3 = $5 per share, or 5 x 100 = $500 for the contract. If the share price had finished at $48, the payoff would be zero and the investor would lose the whole premium of 3 x 100 = $300.Case study
Seen in the real world.
This illustrative story is about a fictional coffee importer, Brindle & Co, which buys beans priced in a foreign currency. The finance director worried about a possible rise in the currency before the next large payment of $1.2 million, due in four months.
She considered a forward contract, which would lock in the rate but also remove any benefit if the currency fell. Instead, she bought a vanilla call option on the currency, paying a premium of $18,000, or 1.5% of the exposure.
Four months later the currency had fallen, so the option expired unused and Brindle bought the currency at the better market rate, saving more than the premium. Had it risen, the option would have capped the cost. The fictional example shows the trade-off between a known cost and open-ended protection.
Watch out
Common mistakes.
- Forgetting that the premium is lost if the option expires worthless. The buyer's loss is capped, but it can be the full premium.
- Thinking a vanilla option obliges the holder to trade. The holder has a right, not an obligation, whereas the seller (writer) of the option has the obligation.
- Ignoring time decay. An option loses value as expiry nears, even if the underlying price does not move.
Questions
People also ask.
What makes an option exotic rather than vanilla?
Special features such as barriers, averaging or payoffs that depend on the path of the price turn a vanilla option into an exotic one.
What is the difference between a European and an American option?
A European option can be exercised only at expiry, and an American option can be exercised at any time before expiry.
Can a company use options to hedge?
Yes, buying options can cap the cost of a future purchase or protect the value of an asset while leaving the benefit of favourable moves.
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