Vanilla

The vanilla (v or van) option is the simplest type of option, with a fixed strike, expiry date and notional amount. It can be:

A callThe owner of a call option has the right to purchase and the writer has the obligation to sell the underlying at a specified price.1 or a putThe owner of a put option has the right to sell and the writer has the obligation to buy the underlying at a specified price.2

EuropeanEuropean style option can only be exercised on the expiry date.3 or AmericanAn American style option can be exercised at any point during the life of the contract up to and including the expiry date.4 style

If it is an American style, it can then be either of the following two transaction types (as defined by the Commodity market convention)—OTC or margined. Depending on the exchange specifications, some listed American vanilla instruments are defined as a margined type, and some are defined as an OTC type.

The payout of a vanilla option (if it is a European style or an American style with an OTC type of transaction) is the difference between the strike and the underlying asset price at exercise or expiration. For the payout of an American vanilla with a margined transaction type, see Transaction Type of American Vanilla Instrument.

There are four basic trades:

Purchase of a call (long call)

The holder of the call option has the right, but not the obligation, to buy the underlying at the strike price on the day of expiry (European style) or any day up to and including expiry (American style).

Sale of a call (short call)

The seller of the call option has the obligation to sell the underlying at the strike price if the holder of this call option exercises the right to buy the underlying at the strike price on the day of expiry (European style) or any day up to and including expiry (American style).

Purchase of a put (long put)

The holder of the put option has the right, but not the obligation, to sell the underlying at the strike price on the day of expiry (European style) or any day up to and including expiry (American style).

Sale of a put (short put)

The seller of the option has the obligation to buy the underlying at the strike price if the holder of this put option exercises the right to sell the underlying at the strike price on the day of expiry (European style) or any day up to and including expiry (American style).

In SDX Commodities & Energy, the vanilla instrument is only supported for the relevant commodities. That is, for commodities that do not have a vanilla instrument, e.g., a European electricity asset, you cannot select one of the vanilla-based instruments.

Why buy a vanilla option?

A vanilla option provides you with protection against adverse movements in the commodity's price. In return for this protection, you pay a premium.

Transaction Type of American Vanilla Instrument

When entering into a Vanilla, if you choose an American style instrument the system supports two transaction types—an OTC type of transaction and a margined type of transaction.

This is in line with the commodity market convention, whereby some listed American vanilla instruments are defined as a margined type, and some are defined as an OTC type. Accordingly, this feature (whereby you can now select the margined type of transaction) lets you price an option that exactly matches the exchange specifications.

The difference between the two transaction types as follows:

In an “OTC” type transaction the premium is paid up front. In addition, the payout is only paid in the event that you choose to actually exercise the option, i.e., at some future point in time. So, as the payout is in fact a future cash flow, accordingly, the premium payment must take the discounting into account.

In a “margined” type transaction, there is no initial exchange of premium at the time of the transaction or indeed at any time over the life of the option, nor is there a single payout (this is because the instrument is not in fact exercised on a one-off basis). Instead, on a daily basis a variation margin is called, i.e., the payments are made according to margined calls.

As the instrument's market value is marked-to-market every day, the current price is always compared to the previous day's price. This result, also known as the variation margin, is then paid or received on a daily basis—according to the changing value of the option. So, if on a given day the option increases in value, the option buyer will receive the variation margin on that day (from the option seller); similarly, if the option decreases in value, the option buyer will pay the variation margin on that day (to the option seller).

As a result, some money goes in and out of the option buyer and the option seller accounts on a daily basis. Therefore, as the mark-to-market is settled on a daily basis, there is no need for discounting.

It is also important to note that although the option buyer may end up losing money, the option buyer's risk (i.e., the total amount of variation margin the buyer may need to pay over the option's lifetime) is limited to the option's initial market value, i.e., the market value on the trade date. You can see this value itself in the Results area, in the Market Premium result.

When you enter into an American style vanilla in the system, the instrument is set to an OTC transaction by default. This is noted in the screen (and as seen in Figure 1 below).

You can then use the OTC <> Margined toggle button to change the transaction type to a margined type instead.

Figure 1: Controlling the Transaction Type for an American Style Vanilla