Known for their simplicity and ease of execution, vanilla options have quickly emerged as one of the most popular financial instruments in the world today. As the market for vanilla options has grown, so too has the marketing hype. As a result, many new and inexperienced traders are having a difficult time separating fact from fiction. In the following article we will break down four myths about vanilla options, helping you determine whether this asset class is suitable for you.
What Is a Vanilla Option?
A vanilla option is a financial instrument that gives traders the right to buy or sell an asset at a predetermined price and within a certain timeframe. In this sense, a vanilla option is a standard call or put option that is traded on the open market, such as the Chicago Board Options Exchange.[1]
If you’re unfamiliar with options, a call option is a contract giving the trader the right to buy a financial asset at a specified price within a certain time period.[2] This contrasts with a put option, which is an agreement giving the trader the right to sell a certain amount of a financial security at a specific price and within a certain timeframe.[3]
Myth 1: Vanilla options and binary options are the same
There appears to be some confusion about vanilla options and binary options. To be sure, the two are not the same. Binary options are similar to ordinary options in the sense that the payoff is based on the price of the asset once the contract expires. In this sense, the trader only needs to determine the direction of the underlying asset price in order to profit. The magnitude of the price change is not important. For this reason, binary options are sometimes called “all-or-none” options. In vanilla options, the trader pays per contract, which is also known as a point. In this case, profit and loss is determined by the price of the underlying security when the option expires minus the strike price of the option.[4]
Myth 2: The magnitude of price changes doesn’t matter when trading vanilla options
In Myth 1 we talked about the difference between vanilla options and binary options. While binary options have an “all or nothing” profit profile, this isn’t the case with vanilla options. With vanilla options, the magnitude of the price change matters. When you trade vanilla options, your payoff is based on the difference between the strike price and the market price at expiry.[5] The strike price simply refers to the price at which the option buyer and seller agree to exchange the security.[6]
Myth 3: Vanilla options are less susceptible to market volatility
Although vanilla options differ from other financial options, they are not exempt from the same underlying market fundamentals that govern financial assets. This is why the premium paid for the vanilla option changes over time. Things like price action of the underlying financial asset, strike price and market volatility all influence the premium paid by the trader. In general, periods with greater volatility will result in higher premiums paid for the option. For this reason, options will be cheaper during periods of less volatility.
Myth 4: You can’t trade longer timeframes with vanilla options
Some traders are under the impression that vanilla options operate like binary options, where contracts expire within 24 hours (in most cases, the contract expiry ranges from 1 minute to a few hours).[7] While vanilla options also provide short expiry rates, contracts up to six months are also available. This gives traders much more flexibility in picking winning trades.
Risk warning: Forward Rate Agreements, Options and CFDs (OTC Trading) are leveraged products that carry a substantial risk of loss up to your invested capital and may not be suitable for everyone. Please ensure that you understand fully the risks involved and do not invest money you cannot afford to lose.Our group of companies through its subsidiaries is licensed by the Cyprus Securities & Exchange Commission (Easy Forex Trading Ltd- CySEC, License Number 079/07), which has been passported in the European Union through the MiFID Directive and in Australia by ASIC (Easy Markets Pty Ltd -AFS license No. 246566).
[1] Vanilla Option. Investopedia.
[2] Call Option. Investopedia.
[3] Put Option. Investopedia.
[4] 4-Traders.com (July 3, 2013). “Vanilla Options versus Binary Options.” 4-Traders.com.
[5] Asset-Or-nothing Call Option. Investopedia.
[6] 4-Traders.com (July 3, 2013). “Vanilla Options versus Binary Options.” 4-Traders.com.
[7] Options Advance. “What Are Expiry Times in Binary Options Trading.” Options Advance.
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