A vanilla option is just an expression meaning a basic formula. An ice cream that is vanilla contains just one simple flavour.
A vanilla option gives the buyer the right but not the obligation to buy a certain volume of a certain asset at an agreed price on an agreed time and day.
An option to buy the underlying is a call option and an option to sell the underlying is called a put option. As options can be bought and sold (traded) it is possible to buy the option to sell and sell the option to buy.
Buying options have a cost involved. This is called the premium. This is similar to an insurance premium that is paid to protect something of value.
How to earn on vanilla options?
Profiting from vanilla options is simple.
If the underlying asset is going to rise in price we simply buy a call option. The price of the option depends on the length of the contract, the strike price in relation to the current market and the volatility of the underlying. These are all factors in whether the ioption will be exercised or not and since it will only be exercised if it is in profit it is also the likelihood of profit.
If the spot is above the price of the call option at execution then we exercise the option and take the profit (less the premium cost). If it is below, we “walk away” but our loss, known in advance is the option premium already paid when the option was struck.
Vanilla options and risk
When buying options the only risk for the buyer is the premium.
It pays to trade options for a risk management perspective. The loss is known, there can be no slippage in the pricing as the potential loss is already well known.
Anyone long of Eur/Chf could have protected their position by buying a Eur put/Chf call option.
When the peg was withdrawn, the underlying position would have lost money but the option would have made money protecting from slippage and providing insurance. If the peg hadn’t been withdrawn, the option premium would have been lost but the underlying position would have made money.
Vanilla options security
Contrary to traders investing on spot or CFD markets, owners of options cannot lose more than they invested (the premium). The ability to reduce and control risk is the biggest advantage of vanilla options.
The owner of the option knows the exact risk – it is limited to the premium. On the other side profit is theoretically unlimited. Just have to remember that put options have limited profit, because price cannot drop below zero. This of course, does not apply on Forex market, here price can always be lower.