Vanilla vs Binary Options

Whilst this article is primarily about binary options, I do not feel it would be complete without including an introduction to vanilla options for several reasons.First, and perhaps most importantly, I believe binary options provide a stepping stone into the world of vanilla options. Second, much of the terminology used in vanilla options is increasingly filtering its way into the binary option lexicon.

Third, binary options, and in particular binary spreads, are now starting to mirror option trading strategies from the vanilla world, and therefore an understanding of the risk and reward profiles of the two, helps to explain where these worlds meet.One such example is the bull spread from Nadex, which we will cover both in this chapter, and also in the next.

This is one of the many examples of a ‘hybrid’ option, which is now drawing together aspects of both the binary and vanilla options worlds. This creates an instrument which combines power vanilla options. Second, much of the terminology used in vanilla options is increasingly filtering its way into the binary option lexicon. Third, binary options, and in particular binary spreads, are now starting to mirror option trading strategies from the vanilla world, and therefore an understanding of the risk and reward profiles of the two, helps to explain where these worlds meet.

One such example is the bull spread from Nadex, which we will cover both in this chapter, and also in the next. This is one of the many examples of a ‘hybrid’ option, which is now drawing together aspects of both the binary and vanilla options worlds. This creates an instrument which combines power your toolkit. And in writing this chapter I hope to achieve two things.

First, highlight the differences in risk profiles between binary and vanilla options. And secondly in doing so, to open your eyes to the future potential vanilla options can offer you as a trader, as your knowledge and experience grows. This chapter will not tell you all you need to know about vanilla options. What I hope to achieve is give you a flavor of how the two compare, the advantages and the disadvantages of each, and in doing so give you a complete picture of the options world from the binary and vanilla perspective.

Vanilla Options:If we begin with the word option, this really does describe the origin and purpose of this instrument. It gives someone the ‘option’ to do something, but they do not have to exercise this option (choice). If you are the holder of an option on something, the choice is yours as to whether you decide to exercise this right which is yours as the option holder. As an option holder (buyer), you have paid a premium and bought the right to exercise this option.

If you have bought an option, someone else has sold an option, and thinking logically, if you have a right to exercise the option, someone on the other side (the counter-party), has the obligation to deliver on the option. This in a nutshell, is what the options market is about. On the one hand you have an option buyer, and on the other you have the option seller.

The option buyer has rights, the option seller has obligations.And herein lies the most fundamental aspect of any vanilla option, in that it is a contract between two parties, a buyer and a seller, and just like any other contract between two parties, one has rights and the other has obligations. For example, a contract between a client and their builder.

The client has the right to expect a completed house to the specification agreed, the builder has an obligation to deliver on time and to budget.For a vanilla option, the contract specifies in very precise terms the amount of the underlying asset, the expiry date, the strike price and the type of delivery of the underlying asset. In other words, a vanilla option is standardized, and can therefore be listed and traded on more than one exchange.

They are referred to as fungible.Vanilla options are quoted as calls and puts, with calls rising in value as the underlying asset increases, and puts rising in value as the underlying asset falls. When you buy an option you pay what is called a premium,and when you sell an option you receive this premium.

The value of the premium changes minute by minute, and day by day depending on the movements in the underlying asset.As an options trader or investor, you can be either a buyer or a seller of an option. However, each has very different contractual obligations and risk profile, depending on whether you are a buyer (holder) or seller (writer).