Vanilla options are a form of contract that guarantees traders the right to either buy a fixed amount of security or sell it at a predetermined date without actually obligating them to do so. Vanilla options give the trader complete control over not just the instrument and quantity he trades but also the timing and price at which he trades.
Following the expiration of the vanilla option, the buyer can either choose to buy or let it expire. Before making a decision on which way to go, keep the following in mind:
- The buyer of the option will be better off exercising his right to transact at the strike rate if the spot rate is less favorable at the time of expiration than it was at the time of purchase.
- If the spot rate at the expiration date is more favorable than its strike rate, then it would be better for the buyer to let it expire and instead go to the spot currency market.
Vanilla options are simply about going for put or call options. A call option allows an investor to buy a specific quantity of currency at a strike price on or before a certain date. A put, on the other hand, ensures that a trader will be able to sell specified amounts of assets at a predetermined price on or before a defined date.
Procedure to exercising options trading
- You should first assess the prevailing market conditions and whether or not they are likely to favor the asset you want to trade. If a trader feels that a specific asset will appreciate, then they can exercise one of three options. The first option would be to buy it directly from the spot market.
- The second alternative is to purchase a call option. By employing this method, the most he stands to lose is the initial premium. It is possible to sell this position at any point in the future. If you are bullish about an asset, this is definitely a good choice.
- Thirdly, the trader may opt to sell a put option. At expiration, if the market price of the tethered asset exceeds the strike price, the option loses value, and the investor will lose their investment.
The working mechanism behind vanilla options trading
A trader who purchases an option, whether a put or a call, pays the transaction fee or the premium from their account, and this sets them up for a potentially highly rewarding trade. The premium received upon selling options is deposited directly into a trader’s account, but the downside to this is that the trader is exposed to potentially endless losses should the market move against his position.
Stop-loss orders can be used on options, just as they can be used on spot transactions, to help traders mitigate this risk. As an alternative to stop losses, the trader may purchase an out-of-money option, which would equally limit its possible exposure.
Options trading carries a low level of risk; the maximum amount of money you can lose is the amount paid for the premium. Trading options is similar to insuring yourself against potential risks in the trade. When you look at it this way, selling options can be a lucrative source of revenue.
In exchange for collecting the premium, if the market reacts in the manner predicted, the trader retains the profits realized as a result of taking that trade. If it turns out that your prediction was wrong, the chances are that you could have been wrong with the spot market as well if you had followed that path.
In either case, the dealer has infinite downturns, but with options, the trader will not end up empty-handed because at least they will earn the premium fee, which is not the case with the spot market.
Hedging with options
In the stock market, a widely publicized method is to sell a covered call, which is to sell a call at a high price while already owning the underlying security. You choose a strike price that corresponds to the amount of profit that you would gladly take. If the price decreases rather than rises, you will have earned the premium, which will help to offset your loss.
In the absence of underlying value, most traders avoid taking long positions for an extended period of time. However, they may expect to be long a certain currency that is on a bull run multiple times during the following few weeks or months. In this case, the traders could opt to sell their currency call options over a period of time that was longer than their longest long position, but they would still believe that they were “covered” the vast majority of the time.
Pros & Cons
- It allows the application of different techniques in a trade.
- Because the maximum loss has been defined, there is less risk.
- It is adaptable and may be customized to meet specific customer requirements.
- It can be used in conjunction with other alternatives.
- Options offer trading opportunities with a high degree of leverage.
- It is effective for diversifying one’s investment portfolio.
- There is a possibility that your transaction costs will cumulatively exceed the forward contract.
- In many cases, it is necessary to have more capital than when trading other trading instruments.
- When you purchase an option, you will be charged a non-refundable premium.
- Changes in the value of the exchange rates of the underlying currency at the time of expiration can lower the value of the option.
Vanilla options have a relatively low-risk exposure and are flexible and implementable using a myriad of trading techniques. You can trade profitably with this approach by following the guidelines discussed above. It is of utmost importance that you assess the different choices available before deciding whether this can work for you.