Vanilla Options

What are Options? Vanilla Options Explained

Vanilla options are contracts giving traders the right to buy or sell a specified amount of an instrument, at a certain price, at a pre-defined time. When trading vanilla options, the trader has the power to control not only the instrument and the amount he trades, but also when and at what price. Options can be traded for over the course of a day, a week, a few months or even a year.

Options’ trading is a mystery for many people. Many would choose trading spot over options because of its seeming simplicity, but once they get into options – traders get hooked. The variety of choices, with the ability to control all aspects of a trade, properly balancing risks and rewards, welcomes traders to an exciting world where they have more control over their activities.

Key Vanilla Options Terminology

It’s important to know the key terms that we use when trading vanilla options. There are two types of options which you will trade:

• Call options

  which give the buyer the right to buy an instrument at a specified price. Call options are more typically bought by traders who believe the market is on the rise, known as bull traders.

• Put options

  which give the buyer the right to sell the instrument at a specified price. Put options are bought by traders speculating the market will go down or bear traders.

You can either buy or sell either type of option.

In order to own an option, the buyer pays the seller an amount called the premium. When the trader acts as the buyer, he pays the premium, and when selling an option, he receives it. The premium is decided by a few factors; the current rate or price of the instrument is the first one. In addition, since options are contracts to trade in the future, there is a time element in play. The date on which the option can be exercised is called the expiration date, and the price at which the option buyer can choose to execute is the strike price. Longer-dated options have higher premiums than shorter-dated options, much like buying insurance.

Market Volatility

Another key factor in determining the premium is the volatility of the underlying instrument. High volatility increases the price of the option, as higher volatility means there is a greater likelihood of a larger market move that can bring about profits – potentially even before the option has reached its strike price. A trader can choose to close his option position on any trading day, profiting from a higher premium, whether it has risen due to increased volatility or the market moving his way.

The effect of market factors on Call/Put Option price

The Basics of Vanilla Options Trading

When buying an option – whether a put or a call – the trader pays the upfront premium from his account’s cash balance, and his potential earnings are limitless. When selling options, however, a trader receives the premium upfront into his cash balance but is exposed to potentially unlimited losses if the market moves against the position, much like the losing side of a spot trade.

To limit this risk, traders can use stop loss orders on options, just like with spot trades. Alternatively, a trader can buy an option further out of the money, thus completely limiting his potential exposure.

When buying options, there is limited risk; the most that can be lost is what you spent on the premium. If you are selling options, which can be a great way to generate income – the trader acts like an insurance company, offering someone else protection on the position. The premium is collected, and if the market reacts according to the speculation, the trader keeps the profits he made from taking that risk. If wrong, it is not much different than being wrong on a regular spot trade.

In either case, the trader is exposed to unlimited downside, and therefore can close out the position (with stop-loss orders, for example), but with options, the trader will have earned the premium, a real advantage vs spot trading.

Steps in Vanilla Option Trading

1. The first step in trading options is to determine the market view for the chosen instrument. If a trader believes a certain instrument will rise, he has three ways to express that view. The first would be to buy the instrument outright, i.e. with regular spot trading.
2. The second is to buy a call option. With this strategy, the most he can lose is the premium, paid upfront. This position can be sold at any time. This is the safest way to express a bullish view.
3. The third course of action is to sell a put option. If the instrument is higher than the strike price at expiration, the option will expire worthless – and the trader keeps the entire premium he collected upfront.

Example Trades

Scenario: The current price for the EURUSD pair is 1.1000. The trader speculates it will rise within the week

Spot trade: In the first case scenario he will open a spot position for 10,000 units, on the platform at the given spreads. If the EURUSD price moves higher, he instantly makes a profit.

Buy Call Option: In the second strategy, he buys a call option with one week to expiration at a strike price, for example, of 1.1020. Once buying, he pays the premium as shown in the trading platform, for example, 0.0050 or 50 pips. If at the expiration date, EURUSD exceeds the strike price, he will earn the difference between the strike price and the prevailing EURUSD rate. His breakeven level will be the strike price plus the premium he paid up front. He can also profit at any time prior to expiration due to an increase in implied volatility or a move higher in the EURUSD rate. The higher it goes, the more he can make.

For example, if at expiration the pair is trading at 1.1100, his option will be 0.0080 or 80 pips “in the money”, and his profit will be 80 pips minus the premium he paid of 50 pips. On the other hand, if spot is below the strike at expiration, his loss will be the premium he paid, 50 pips, and no more.

Sell Put Option: In the third case, he will sell a put option. Meaning he will act as the seller, and receive the premium directly to his account. The risk he takes by selling an option is that he is wrong about the market – and so he must be careful in choosing the strike price. He should be comfortable in his view that EURUSD will not be below this level at expiration.

Another way to say it is that he must be comfortable buying EURUSD at the strike price because if spot finishes lower, the seller has the right to “put” EURUSD to him at the strike price. In return for taking this risk, the option seller receives the upfront premium. If spot finishes higher than the strike price, he keeps the premium and is free to sell another put, adding to his income earned from the first trade.

In both options trading examples, the premium is set by the market, as shown in the  Currency Hedger Options trading platform at the time of the trade. The gains and losses, based on the strike price, will be determined by the rate of the underlying instrument at expiration.