The concept of vanilla options and their application

Vanilla options (or vanilla products) are contracts that give you the right, but not the obligation, to buy or sell a specific quantity of a financial instrument at a set price on a specific date. Unlike futures contracts, you are not obligated to buy the asset if you don't want to do so. Vanilla options are so called because they have no special or additional features like exotic options.

How vanilla options work and their profitability

There are two types of vanilla options: call and put, which can be bought or sold:

• Buying a call option gives you the right, but not the obligation, to buy an asset at a set price on a specific date. This gives you a long position in the market, so you buy a call if you believe the price of the asset will rise;
• Buying a put option gives you the right, but not the obligation, to sell the asset at a set price on a specific date. In this case, you will have a short position in the market, so you will buy a put if you believe the market will fall;
• Selling a call option gives you a commitment to sell the asset at a set price on a certain date. You will sell a call if you believe the market will remain stable or go down;
• Selling a put option gives you a commitment to buy an asset at a specific price on a specific date. You will sell a put if you believe the market will remain stable or go up.

When trading vanilla options, the amount you pay for the right to buy or sell an option is called the premium. Buying an option offers potentially unlimited profits, whereas selling limits your profits to the premium but can result in significant losses if the market goes against you. Therefore, before selling vanilla options, it is important to make sure you understand the risks and are prepared for potential losses.

Are vanilla options a leveraged product?

Vanilla options, like CFDs, are a leveraged product, but they work slightly differently. When you buy vanilla options, the premium you pay is usually much less than the cost of investing in the underlying asset, be it oil, gold or stocks. While leveraged products can significantly increase your gains, they also increase your potential losses if the market moves against you.

How are vanilla options priced?

Unlike barrier products, which simply move one-to-one with the price of the underlying asset, there are a number of factors that influence the price of vanilla options. The three most important variables affecting the price of vanilla options are:

• The level of the underlying market: The probability that an option will expire at any value increases as the underlying asset becomes more and more in-the-money, i.e. above the strike price on the profitable side. Therefore, the further the option is in the money, the higher the premium.
• Time to expiration: The further in the future an option expires, the more time is left before it is in the money. An option with a longer time to expiration usually has a higher premium.
• Underlying Market Volatility: The more volatile the underlying asset, the more likely an option is to go from being in-the-money to out-of-the-money. Increased volatility usually leads to higher option prices, increasing the risk for sellers.

What are ‘Greeks’ in options trading?

‘Greeks’ are measures of variables that help determine the price of options and calculate risk. The main ‘Greeks’ include:

• Delta: Measures the sensitivity of an option to the price of the underlying market, showing how many points the option's value will change for each point of movement in the price of the underlying asset;
• Theta: Measures the effect of time on the value of an option by showing how much the option's price will decrease as the expiry date approaches;
• Vega: Measures the sensitivity of an option to market volatility, showing how much the option's value will change if volatility changes by 1%.

How to trade vanilla options?

Vanilla options allow you to take advantage of opportunities in both rising and falling markets, and are suitable for a variety of trading strategies. To get started, it's important to understand the difference between buying and selling vanilla options. When buying an option, you pay a premium, which is your maximum risk. When you sell options, the risk is much higher because the market price can exceed the strike price of the option.

Choosing a vanilla options trading strategy

Vanilla options are suitable for a variety of strategies that cannot be implemented with other instruments. The main strategies include:

• Married Put: Buying a put option on an asset you already own to hedge against falling prices. If the price of the asset falls, the profit on the put will offset the loss;
• Long Straddle: Buying the same put and call options in the same market with the same strike price and expiry date to capitalise on high volatility, regardless of the direction of the market;
• Bullish Call Spread: Buying and selling call options in the same market but with different strike prices. This strategy reduces the premium but limits the potential profit.

Opening an account to trade options

To trade vanilla options, you need to open an account, which can be done for free and without obligation. Both vanilla and barrier options are available. For practice, you can use a demo account with virtual funds, which will allow you to learn the basic mechanics without the risk of real losses.

Placing your first order

After selecting a strategy and funding your account, you can place your first order to buy or sell vanilla options. IG vanilla options allow you to take positions in assets whether the market is rising or falling.

Conclusion

Trading vanilla options requires knowledge of their peculiarities and risks. Start with a demo account and small trades to minimise risks. Gradually build up experience to improve your results.