What are Vanilla Options?
When discussing options in terms of simplicity, we can group options trades into two groups:
a) Binary options (fixed rate return options, all or nothing options, digital options)
b) Vanilla options (also called plain vanilla options)
Some of the options that have been discussed such as covered calls, butterfly options, iron condors, etc, are complex trade types and fall under the category of exotic options, but they use vanilla options. For this discussion, we will talk about plain vanilla options, which are the basic type of options trades that we have, without all the complexities of the other trade types. So just as we have all manner of flavours for ice cream, the vanilla flavour is a simple, straightforward flavour. If you can look at vanilla options in this context, then you can understand what they are.
A plain vanilla option gives the options trader the right but not the obligation, to buy or sell a financial instrument at a certain price and at a certain date. The certain price is known as the strike price while the specified date is the expiration date; a date at which settlement of the option contract must be performed by all parties to the contract.
A vanilla option can be a call or put option and the terms are pretty much standard. There are no special features. The trader, who in this case is usually the buyer, is not obligated to cash-in on the option contract on expiry. This is usually dependent on if the price of the underlying asset is above or below the strike price by the time the option expires.
Characteristics of Vanilla Options
Vanilla options share certain characteristics:
1) Vanilla options trades can only be in one direction; call or put.
2) A trader can decide to purchase a vanilla option and sell it off before the expiration date.
3) Vanilla options can be listed across several expiration periods with multiple strike prices.
4.) Vanilla are the traditional options on stocks. You can buy them or short them
In addition to a maximum loss/profit, there are two breakeven points located at the levels of the short call (+ net premium) and the short put (less net premium).
As in other options trade types, the trader must analyse the underlying asset to see that it will probably remain unchanged by expiration, in order to get this trade right. If the trader is able to get this right, then he will smile to the bank on payday.