Do you think using vanilla options can enhance your trading profits? For many people all over the world, using the simplest versions of options contracts can offer safety for any size portfolio. That’s because an options contract works as a sort of insurance policy should prices go off in a direction you didn’t expect.
Vanilla Options Trading – Definitions, Examples
Of course, there’s much more to the concept than that. If you want to know when to use a vanilla option contract, it’s wise to review what they are and how they work. After that, it’s much easier to comprehend how vanilla options can protect you against unexpected price volatility.
What and How
In financial trading, options are contracts with a set expiration date. Each contract is for 100 shares of the underlying stock. If you are the owner of a vanilla option, you have the right to purchase 100 shares of the related stock at the strike price, on or before the date of expiration.
Plus, each contract comes with a strike price, which is the dollar value which the trading price of the underlying stock must touch before the vanilla option can be exercised.
The above explanation only spoke of call options, which give the holder of the contract the right to buy at a designated dollar value. A put option is the opposite. It gives the holder the right to sell 100 shares at the strike price on or before expiration.
When should you use a vanilla option? There are dozens of times that doing so is profitable. However, two of the most common are when you want to protect against rapidly falling prices for stock you already own. The second is when you want to take advantage of an expected rise in the cost of shares you do not own.
If you work with a professional options broker, you’ll get some important guidance when placing your first few orders. The important thing to remember is that options are tricky, so it’s essential to understand the fundamentals of how they work to protect your other positions. Here’s more about each of the two examples noted above.
Protecting Your Assets
Say you own 1,000 shares of ABC Corp. in order to diversify your portfolio and are afraid that prices might fall, based on how you interpret recent news stories, for example. If ABC currently sells for $100, a drop to $60 or $50, based on the bad news, could cost you a fortune.
So, you could buy 10 put vanilla options, each one representing the right to sell 100 units at a specified price within a particular timeframe, perhaps one month. If you purchase 10 vanilla option puts for $5 each, for $50 total, and the strike price is $95, with expiration date of one month from today, you have insurance.
If ABC starts to drop in value, your vanilla option puts give you the legal right to sell all your holdings for $95, regardless of how low they sink in value, as long as you complete the transaction before the expiry date.
If you own zero shares of ABC, but think the price will shoot up soon, you could buy a call vanilla option, essentially doing the reverse of the above scenario. If ABC indeed leaps in value, your vanilla option calls give you the right to purchase at the strike price, not the new, extremely high value.