In the world of structured products, understanding the intricacies of vanilla options is crucial for any savvy investor, especially for our HNWCs. These fundamental building blocks of more complex financial instruments offer a range of strategies to suit varying market conditions. Whether you're looking to leverage bullish trends, hedge against potential downturns, or capitalize on market stability, mastering vanilla options is your gateway to tailored investment strategies.

Summary

• Vanilla Options, European vs. American Options
• Long/Short Call/Put
• Bull/Bear Call Spread and Bull/Bear Put Spread
• Buy/Sell Straddles/Strangle

In our last structured product series article – Understanding Structured Products: An Introduction for Investors Series 1, we learned that structured products are option-embedded to achieve complicated investment objectives. In this article, we are going to explore the various vanilla options that constitute structured products.

Vanilla Options

A vanilla option is a simple call/put option with no special features or observation dates. It gives the holder a time-limited right, but not obligation, to buy or sell an instrument at a predetermined price, in exchange for a premium. Basic vanilla option strategies include: Long/Short Call, Long/Short Put, Bull/Bear Call Spread, Bull/Bear Put Spread, Buy/Sell Straddle, Buy/Sell Strangle, etc.

European vs. American Style Options

European Style Options: Can be exercised only at expiration and are globally OTC traded.

American Style Options: Can be exercised at any time prior to expiration and are exchange traded.

This article will focus on European Style Options which are the most common products for HNWCs to trade on the OTC market.

Vanilla Option Strategies

Long Call

A long call strategy anticipates the underlying asset's price (S) to rise above the strike price (K) at maturity (S  > K). This bullish strategy profits from the asset's upside.

• S  ≤ K: The option holder doesn't exercise the call, incurring a loss limited to the premium paid.
• S  > K: The holder exercises the call, resulting in a PnL = S  - K - Premium
• The breakeven is when S  = K + Premium.

Application:

For example, the current share price of Tesla (TSLA UW) is USD 263.26. If we expect its price to rise in the next 3 months, we could buy a call option of 3-month tenor with strike price USD 268 to profit from the upside of TSLA (buying TSLA stocks at USD 268 at maturity when market price is already USD 290 if bullish) while being protected from potential downside (not exercising call option at maturity if bearish).

Long Put

A long put strategy anticipates the underlying asset's price (S) to fall below the strike price (K) at maturity (S  < K). This bearish strategy profits from the asset's downside.

• S ≥ K: The option holder doesn't exercise the put, incurring a loss limited to the premium paid.
• S > K: The holder exercises the put, resulting in a PnL = K - S – Premium
• The breakeven is when S  = K - Premium.

Application:

For example, the current share price of Nvidia (NVDA UW) is USD 134.91. If we think it is overpriced and expect it to drop in the next 30 days, we could buy a put option of 1-month tenor with strike price USD 130 to profit from the downside of NVDA (selling NVDA stocks at USD 130 at maturity when market price is USD 120 if bearish) while being protected from potential upside (not exercising put option at maturity if bullish).

Short Call

A short call strategy anticipates the underlying asset's price (S) to stay below the strike price (K) at maturity (S ≤ K). This bearish strategy aims to earn the premium from selling the call option without incurring losses.

• S ≤ K: The option holder does not exercise the call. The writer's PnL is limited to the premium earned.
• S > K: The holder exercises the call, resulting in a PnL = Premium - (S - K), but the loss is potentially unlimited as S increases.
• The breakeven is when S = K + Premium.

Application:

For example, the current share price of Panasonic (6752 TYO) is JPY 1351 and is not performing well with YTD return of -5.92%. We bought its shares last year at cost of JPY 1430 and expect its price to go further down in the next 6 months. We could sell a covered call option of 6-month tenor with strike price JPY 1450, higher than our cost of purchase JPY 1430. We could either earn the premium to compensate for our loss if bearish or offload the underperforming stocks at JPY 1450 to compensate our initial cost of purchase if bullish.

Short Put

A short put strategy anticipates the underlying asset's price (S) to stay above the strike price (K) at maturity (S ≥ K). This bullish strategy aims to earn the premium from selling the put option without incurring losses.

• S ≥ K: The option holder does not exercise the put; the writer's PnL is limited to the premium earned.
• S < K: The holder exercises the put, resulting in a PnL = Premium - (K - S).
• The breakeven is when S  = K - Premium.

Application:

For example, the current yield of 10YUST is 4.29%. The price of 10YUST is inversely related to interest rates. If we expect the interest rate to rise and 10YUST price to fall in the next 3 months, we could sell a put option of 3-month tenor with strike price 95% to either earn the premium if bullish or buy the 10YUST at 95% and enjoy the coupon paid from 10YUST if bearish.

Spread Options

Spread options are vanilla option strategies that involve simultaneously buying and selling a call/put option with different strike prices and the same expiration date. The purpose is to limit potential losses and gains, making it a risk-managed way to speculate on the price movement of the underlying asset. For example, call spread is often used in a structure product – PPN Booster which we shared in previous article.

Bull call spread: Buy a call option at a lower strike price (K1) + Sell a call option at a higher strike price (K2).

• S ≤ K1: neither call options will be exercised. PnL = difference between two premiums (P2 - P1).
• K1 < S ≤ K2: buy call option will be exercised. PnL = S - K1 + (P2 - P1), increasing as S approaches K2. The breakeven is when S - K1 = P1 - P2.
• S > K2: both call options will be exercised. PnL = K2 - K1 + (P2 - P1)

Application:

For example, the current share price of Broadcom (AVGO UW) is USD 1744.69. If we expect it to rise within a range in the next 3 months, we could buy a call spread (buying a call at lower strike price USD 1770 and selling a call at higher strike price USD 1800) to profit from the upside if bullish or compensate the premium paid if bearish.

Bear call spread: Sell a call option at a lower strike price (K1) + Buy a call option at a higher strike price (K2).

• S ≤ K1: neither call options will be exercised. PnL = difference between two premiums (P1 - P2).
• K1 < S ≤ K2: the sell call option will be exercised. PnL = K1 – S + (P1 - P2), decreasing S approaches K2. The breakeven is when S - K1 = P1 - P2.
• S > K2: both call options will be exercised. PnL = K1 - K2 + (P1 - P2).

Application:

For example, the current share price of Samsung (5930 KRX) is KRW 87500. If we expect it to fall moderately within a range in the next 1 month, we could sell a call spread (selling a call at lower strike price KRW 85000 and buying a call at higher strike price KRW 88000) to profit from premium earnings if bearish or limit our loss if bullish.

Bull put spread: Buy a put option at a lower strike price (K1) + Sell a put option at a higher strike price (K2)

• S > K1: both put options will be exercised. PnL = difference between two strike prices and two premiums K1 - K2 + (P2 - P1).
• K1 ≤ S < K2: the sell put option will be exercised. PnL = S - K2 + (P2 - P1), increasing as S approaches K2. The breakeven is when S - K2 = P1 - P2.
• S ≥ K2: nether put options will be exercised. PnL = P2 – P1

Application:

For example, the current share price of Apple (APPL UW) is USD 232.98. If we expect it to rise moderately within a range in the next 1 month, we could buy a put spread (buying a put at lower strike price USD 215 and selling a put at higher strike price USD 220) to profit from its upside if bullish or compensate the premium paid if bearish.

Bear put spread: Sell a put option at a lower strike price (K1) + Buy a put option at a higher strike price (K2). P1 < P2 for the above-mentioned reason.

• S < K1: both put options will be exercised. PnL = difference between two strike prices and two premiums K2 - K1 + (P1 - P2).
• K1 ≤ S < K2: the buy put option will be exercised. PnL = K2 - S + (P1 - P2), decreasing as S approaches K2. The breakeven is when K2 - S = P2 - P1.
• S ≥ K2: nether put options will be exercised. PnL = P1 - P2.

Application:

For example, the current share price of Alibaba (9988 HK) is HKD 74.9. If we expect it to drop within a range in the next 6 months, we could sell a put spread (selling a put at lower strike price HKD 60 and buying a put at higher strike price HKD 85) to profit from its downside if bearish or limit our loss if bullish.

Straddle Options

A straddle option involves simultaneously buying or selling a call and a put option with the same strike price and the same expiration date.

Buy Straddle: Buy a call option + Buy a put option with the same strike price (K) and same expiration date.

• S < K: the buy put option will be exercised. PnL = K - S - (P1 + P2), limited to maximum plunges of S. The buy put breakeven is when K - S_T = P1 + P2.
• S = K: neither buy nor put options will be exercised. PnL = -(P1 + P2).
• S > K: the buy call option will be exercised. PnL = S - K - (P1 + P2), unlimited as S skyrockets. The buy call breakeven is when S - K = P1 + P2.

Application:

For example, the current strike price of Micron (MU UW) is USD 136.39. If we think its price is highly volatile in the next 3 months and are willing to pay higher premiums, we could buy a straddle (buying a put and a call at the same strike price USD 130) to profit from its high volatility and limit our loss to the premium paid.

Sell Straddle: Sell a call option + Sell a put option with the same strike price (K) and same expiration date.

• S < K: the sell put option will be exercised. PnL = (P1 + P2) + S - K, limited to maximum plunges of S. The sell put breakeven is when K - S = P1 + P2.
• S = K: neither buy nor put options will be exercised. PnL = P1 + P2.
• S > K: the sell call option will be exercised. PnL = (P1 + P2) + K - S, unlimited as S skyrockets. The sell call breakeven is when S - K = P1 + P2.

Application:

For example, the current share price of Coca-Cola (KO UN) is USD 62.83. If we think its price is stable in the next 6 months and want to maximize premium income, we could sell a straddle (selling a put and a call at the same strike price USD 63) to profit from premium earnings and compensate our loss if high volatility.

Strangle Options

A strangle option strategy involves simultaneously buying or selling both a call and a put option on the same underlying, with the same expiration date but different strike prices. This strategy is typically used to profit from anticipated large price movements in the underlying asset, regardless of the direction of the move.

Buy Strangle: Buy an OTM put option (K1 < Current Price) + Buy an OTM call option (K2 > Current Price)

• S < K1: the buy put option will be exercised. PnL = K1 - S - (P1 + P2), limited to maximum plunges of S. The buy put breakeven is when K1 - S = P1 + P2.
• K1 ≤ S ≤ K2: neither buy call nor put options will be exercised. PnL will be = -(P1 + P2).
• S > K2: the buy call option will be exercised. PnL = S - K2 - (P1 + P2), unlimited as S skyrockets. The buy call breakeven is when S - K2 = P1 + P2.

Application:

For example, the current share price of AMD (AMD UW) is USD 183.96. If we think its price is moderately volatile in the next 3 months and prefer a cheaper premium strategy, we could buy a strangle (buying a put at lower strike price USD 155 and a call at higher strike price USD 200) to profit from its high volatility and limit our loss to the premiums paid.

Sell Strangle: Sell an OTM put option (K1 < Current Price) + Sell an OTM call option (K2 > Current Price)

• S > K1: the sell put option will be exercised. PnL = (P1 + P2) + S - K1, limited to maximum plunges of S. The sell put breakeven is when K1 - S = P1 + P2.
• K1 ≤ S ≤ K2: neither sell call nor put options will be exercised. PnL = P1 + P2.
• S > K2: the sell call option will be exercised. PnL = (P1 + P2) + K2 - S, unlimited as S skyrockets. The sell call breakeven is when S - K2 = P1 + P2.

Application:

For example, the current share price of Procter & Gamble (PG UN) is USD 166.8. If we think its price is moderately volatile in the next 3 months and prefer a low-risk strategy with a wider range of probability, we could sell a strangle (selling a put at lower strike price USD 155 and a call at higher strike price USD 175) to profit from the premiums earned and limit our loss if still high volatility.

There are still various vanilla option strategies left to explore. Mastering these basic vanilla option strategies will be beneficial to react instantly to and trade appropriately to deploy different market conditions for profits maximization and risk hedging. Vanilla options are also the core components of exotic options and structured products which HNWCs trade daily. In the next series article, we will explore how these vanilla option strategies are implemented in structured products. Stay tuned for more interesting and rewarding sharing!