# Understanding Vanilla Options: Types, Features, and Real-world Examples

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A vanilla option is a financial security that gives its holder the right to buy or sell an [underlying asset](https://www.investopedia.com/terms/u/underlying-asset.asp) at a predetermined price (the strike price) within a specific period of time. It is either a [call](https://www.investopedia.com/terms/c/calloption.asp) or [put](https://www.investopedia.com/terms/p/putoption.asp) option and has no added features that other types of options might have. However, vanilla options can be combined with exotic and binary options to create custom outcomes. Traders and institutions use vanilla options for hedging and speculation purposes. Buyers of options have no obligation to exercise their option.

### Key Takeaways

*   Vanilla options provide the right, but not the obligation, to buy or sell an asset at a set price within a timeframe.
*   There are two types of vanilla options: call options allow buying, and put options allow selling of an asset at the strike price.
*   Premiums for options depend on factors like proximity to the strike price, asset volatility, and time until expiration.
*   Investors use vanilla options to hedge risks or speculate on price movements in the financial markets.
*   Exotic and binary options can be combined with vanilla options for more customized financial strategies.

## Understanding the Fundamentals of Vanilla Options

People and companies use vanilla options to [protect](https://www.investopedia.com/terms/h/hedge.asp) against asset price risks or bet on price changes of financial instruments.

When vanilla options don't suit an investor, [exotic options](https://www.investopedia.com/terms/e/exoticoption.asp) like [barrier](https://www.investopedia.com/terms/b/barrieroption.asp), [Asian](https://www.investopedia.com/terms/a/asianoption.asp), and [digital](https://www.investopedia.com/terms/b/binary-option.asp) options offer more customization. These complex options are usually traded over-the-counter and can be combined to lower costs or boost leverage.

## Exploring Call and Put Vanilla Options

There are two types of vanilla options: calls and puts. The owner of a call has the right, but not the obligation, to buy the underlying instrument at the [strike price](https://www.investopedia.com/terms/s/strikeprice.asp). The owner of a put has the right, but not the obligation, to sell the instrument at the strike price. The seller of the option is referred to as its [writer](https://www.investopedia.com/terms/w/writing-an-option.asp). Shorting or writing an option creates an obligation to buy or sell the instrument if the option is exercised by its owner.

Calls and puts both have an [expiry date](https://www.investopedia.com/terms/e/expirationdate.asp). This puts a time limit on how long the underlying asset has to move.

For example, say stock XYZ is trading at $30, the call option has a $31 strike price expiring in a month, and the [premium](https://www.investopedia.com/terms/p/premium.asp) is $0.35. A contract, which covers 100 shares, costs is $35.

If XYZ stock price rises over $31, the option is [in the money](https://www.investopedia.com/terms/i/inthemoney.asp). However, it must rise above $31.35 for the buyer to profit. The buyer's maximum loss is the option cost, while profit potential is unlimited and based on further price increases.

The option writer collects $35 ($0.35 x 100 shares) for writing the option. If the price of XYZ stock stays below $31, the option is said to be [out of the money](https://www.investopedia.com/terms/o/outofthemoney.asp) and the writer keeps the premium. However, if the price rises above $31, the option writer has an obligation to sell that stock to the option buyer at $31. For example, if the stock rises to $33, this would represent a loss of $165, or ($33 – $31) x 100 = $200, then subtract the $35 premium already collected for a loss of $165.

## Key Features of Vanilla Options Explained

Every option has a strike price. If the strike price is better than the price in the underlying market at maturity, the option is deemed "in the money" and can be [exercised](https://www.investopedia.com/terms/e/exercise.asp) by its owner. A [European style](https://www.investopedia.com/terms/e/europeanoption.asp) option requires the option be in the money on the expiration date in order for it to be exercised. An [American style](https://www.investopedia.com/terms/a/americanoption.asp) option can be exercised if it is in the money on or before the expiration date.

The premium is the price paid to own the option. The premium is based on how close the strike is to the price of the underlying (in the money, out of the money, or [at the money](https://www.investopedia.com/terms/a/atthemoney.asp)), the volatility of the underlying asset, and the time until expiration. Higher volatility and a longer maturity increase the premium.

An option gains [intrinsic value](https://www.investopedia.com/terms/i/intrinsicvalue.asp), or moves into the money, as the underlying surpasses the strike price—above the strike for a call and below the strike for a put. 

Option traders don't need to wait until expiry to close out an options trade, nor do they need to exercise the option. They can take an offsetting position at any time to close the options trade and realize their profit or loss on the option.

## Combining Vanilla and Exotic Option Strategies

Two other types of options can be combined with vanilla options to create tailored outcomes. The first type are exotic options, which have conditions or calculations attached to their execution. For example, barrier options include a level that, if reached, causes the option to begin to exist or cease to exist. Digital options pay the owner if the underlying is above or below a specific price level. An Asian option's payoff depends on the average traded price of the underlying instrument during the life of the option.

The second type of options which can be combined with vanilla options are [binary options](https://www.investopedia.com/terms/b/binary-option.asp). The outcome of such options is typically restricted to just two possible results, meaning that the payouts are also restricted. They are typically used to speculate on price movements of an asset. A possible combination between binary and vanilla options would be the purchase of a call/put vanilla option and a binary option in the opposite direction of the former.

## The Bottom Line

Vanilla options are basic options that provide their buyers with the right to buy or sell an asset at a predetermined price within a specific frame of time. Holders are under no obligation to exercise an option and can simply let them expire. Key features include the strike price, premium, time period, and the potential profit or loss for both buyers and writers (also known as sellers). Many vanilla option holders buy them to hedge another position in the market or to speculate on the option's changing price. These options can be combined with exotic or binary options for tailored financial strategies. Before investing, investors should understand the type of option that's best for them based on their individual financial goals and risk tolerance.  

_**Correction—Sept. 3, 2024**:_ This article has been corrected with the proper formula for determining the loss in the example of calls and puts.