Once you’ve started investing, you may want to learn about different assets beyond stocks and bonds. Among the alternative assets you might consider, are options, and vanilla options are a great way to get started with this type of investment.
Options give investors the — you guessed it — option to purchase or sell a stock at a certain price over a certain period. Options are derivative financial instruments, which means they are based on an underlying asset. Vanilla options are the most basic type of option contract, and they’re often standardized and traded on exchanges.
Vanilla Option Definition
Vanilla options, in contrast to exotic options, which have customization features, have simple and straightforward terms of the strike price, or the price for which an investor buys or sells a stock, and the period in which they can exercise their option. The last day that an investor may exercise an option is known as the expiry date.
How Do Vanilla Trades Work?
Let’s look at how options trading works with vanilla trading.
Each option has a strike price. If that price for purchase is lower than the market value of the stock, investors call that option “in the money.”
Investors pay a premium to own an option. This premium reflects several factors, including:
• How close the strike price is to the market price
• The stock’s volatility
• How length of time before the option expires
Investors don’t have to wait until the option expires to complete the trade, and they are typically under no obligation to exercise the option.
Recommended: Popular Options Trading Terminology to Know
What are the Different Types of Vanilla Options?
When it comes to options for vanilla stock options, there are two types, calls and puts.
A vanilla call option gives an investor the option to buy an asset at a certain price within a certain period. A call option is a bit like a down payment; the investor pays the premium so that, later, they can buy the stock at a good price and profit from it.
However, an investor can pay the premium and never exercise the option. If they decided not to exercise it, they would either lose what they paid for the premium, or they could sell the call option to someone else before it expires.
In contrast, a put option allows an investor to sell an asset at a fixed price within a certain time period. If a stock tanks in value over the period that option is exercisable, the investor can still sell it for the put price and not lose as much of his investment. But if the stock’s value goes higher than the put price in the market, the vanilla options are worthless because the investor could sell it at the market price and realize more of a profit.
Characteristics of Vanilla Options
Like all investments, vanilla options include a level of risk and volatility. But they can also provide the opportunity for profit.
Whether you are interested in a vanilla call or put, you will pay a premium, in addition to what you would pay to purchase the stock with a call. The premium isn’t refundable, so if you don’t exercise the option, you’ve lost what you paid for the premium.
The volatility of an option determines its price. The higher the volatility of the option, the higher the premium because there is more opportunity for profits (as well as the risk of loss).
One way to reduce volatility is to use an options trading straddle where you buy a put and call option simultaneously.
Like most other types of investments, options are not without risk. If a stock is lower in price on the market than a call option, the option is worthless. And if a stock has a higher price on the market, the put option won’t net more return on investment.
However, a vanilla option may be less risky than buying a stock outright, since the only thing you’re guaranteed to spend is the premium.
Pros and Cons of Vanilla Options Trading
Trading vanilla options can have potentially great returns…or large losses. Here are the pros and cons.
|Minimizes risk; no obligation to exercise||Risky; may lose premium investment and more|
|Option to control more shares than buying them outright||May be complex to understand|
|May offer large returns||Fluctuations in market may render option worthless|
Options may be less risky than buying a stock outright, since you’re only buying the option to purchase or sell a stock at a certain price. The premium is all you invest initially.
Typically you can purchase more shares through options than you could buying them on the market, so if you’re looking for larger investment opportunities, options could provide them.
And while they’re volatile, there is the potential for larger returns.
That being said, you don’t always see large returns. You can lose your entire investment if the option is out of the money when it expires.
Options can be complicated or confusing for new investors. Not only should you fully understand the risks you take with this investment tool, but you also should understand options taxation.
Examples of Vanilla Options
If you’re considering vanilla options as part of your options trading strategy, here are a few examples to illustrate how they work for both calls and puts.
Example of a Vanilla Put Option
A put is a bit like insurance in case your stock you’re holding goes down in value. It’s one way that investors might short a stock. Here’s an example.
Let’s say you own 100 shares of a stock that is currently trading at $25 per share. You buy a put option at a premium of $1 per share that expires in two months at a strike price of $25. So in total, you paid $100 for a premium for 100 shares.
In a month, the stock price drops to $18 per share. This is a good time to exercise that premium because your strike price allows you to sell the shares for $25 rather than $18. You wouldn’t gain any money because you’re essentially selling the stocks for what you paid for them ($25), and you would even lose a little (that $1 per share premium), but the alternative would be to lose even more if you waited and the price dropped more or you didn’t have the option.
Example of a Vanilla Call Option
A call option allows you to purchase a stock at a certain price within a specified time period. Bullish investors who expect a stock to go up in price typically purchase call options.
For our example, let’s say you’re interested in a stock that trades at $53, and you can buy a call option for this stock within one month to purchase the stock at $55 per share. The option is for 100 shares of this stock.
The premium for this option is $0.15 per share. So you would pay $15 for the premium. You aren’t obligated to purchase the stock. If the stock trades at more than $55.15 (option price plus premium), you can realize a profit.
Let’s say in two weeks, that stock is trading at $59. It is, as they say, “in the money.” Now would be a great time to exercise your option because you can realize $3.85 per share and $385 for 100 shares. You can sell the shares immediately to cash in on that profit or hold onto it to see if the stock price continues to rise.
Vanilla stock options are a way to diversify your investment portfolio and increase your investing savvy. While SoFi does not offer options trading, it does allow you to build a portfolio of stocks, exchange-traded funds, and even IPOs or cryptocurrency. You can get started by opening an account on the SoFi Invest brokerage network.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.