What is a digital option?
A digital option is a type of option contract that has a fixed payment if the underlying asset exceeds the predetermined threshold or the exercise price. There is an initial charge called the premium for digital options, which is the maximum loss for the option.
Unlike traditional options, digital options are not converted or exercised on the shares of the underlying asset. Instead, they pay a fixed reward if the asset price is higher or lower than the exercise price of the option. Numeric options are also called “binary options” or “all or nothing”.
Explanation of options
Options are financial derivatives, so they receive their value from an underlying asset or security. Traditional options give buyers the option, but not the obligation, to trade the underlying security at a predetermined price – called the strike price – on the expiration date – or the end date of the contract.
Options come with a premium, which means they have an initial charge. The premium may fluctuate over time and vary from one option to another depending on the value of the underlying security, the proximity of the option to its expiration, the exercise price and the level of demand for the option on the market.
The value of the premium can also provide an overview of the value that investors place on the option and the underlying security. An option that has value will likely have a higher premium than an option that will likely not make a profit by its expiration date. Options are available for many securities, including stocks, currencies like the euro, and commodities like crude oil, corn and natural gas.
Key points to remember
- Digital options are a type of option contract that has a fixed payment if the underlying asset exceeds the predetermined threshold or the exercise price.
- The initial charge called premium is the maximum loss for digital options.
- Unlike traditional options, digital options are not converted or exercised on the shares of the underlying asset.
Unique features of digital options
Numeric options differ from traditional options in that they do not transfer ownership of the shares when they are exercised or on their expiration date. Instead, digital options pay the fixed amount to the investor if the price of the underlying security is higher or lower than the strike of the option at maturity. The value of the payment is determined at the start of the contract and does not depend on the extent of the change in the price of the underlying.
If the underlying asset expires in the money, which means that the option is profitable, the option is automatically paid to the trader who receives the profit. If the option expires out of the money, which means that it is not profitable, the investor’s maximum loss is limited to the initial premium, regardless of the price movements of the underlying.
A digital option is simply a bet or a bet that the price of the underlying asset will be higher or lower than the strike price at a certain time and date. If an investor thinks that the price of the underlying will be higher than the strike, the option will be bought. Conversely, if an investor thinks that the price of the underlying will be lower than the strike, the option will be sold.
List and regulation of digital options
Unlike vanilla options, the sale of a digital option does not mean that the trader subscribes an option, which implies that the seller or the writer pays a fee to allow the buyer to exercise the option. In most cases, investors who sell traditional options use them as an income strategy and hope that the option will not be exercised so that they can keep the premium.
Selling a digital option is equivalent to buying a put option whereby the investor expects the underlying to be lower than the strike price at maturity. Some digital options brokers break these options down into call and put options, while others have only one option where traders can buy or sell, depending on the direction in which they expect the price goes.
Call options are purchased when the price of the underlying is expected to rise. Put options are purchased when the price of the underlying is expected to fall.
Digital options may appear similar to standard option contracts, but they can be traded on unregulated platforms. As a result, digital options may carry a higher risk of fraudulent activity. Investors wishing to trade digital options must use platforms regulated by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
Nadex is a regulated digital options broker in the United States. The platform provides strike prices and expirations for various underlying assets. All options have a value of $ 100 or $ 0 at maturity. The maximum payment is $ 100 and the premium varies depending on the strike and the price of the underlying security. So if a premium is $ 50, the maximum payment is also $ 50, because the maximum value of each contract is $ 100. If the premium is $ 30, the maximum payment is $ 70 for this option.
Traders buy the option if they think the price of the underlying will be higher than the strike at maturity. If they think the underlying will be lower than the strike, they sell the option.
Digital options pay a fixed amount if the underlying asset exceeds the predetermined threshold or the strike price.
The maximum loss for digital options is limited to the initial fee or premium.
Unlike traditional options, digital options are not converted or exercised on the shares of the underlying asset.
The benefits of the digital option are limited to fixed payment.
Digital options can be risky if traded on unregulated platforms.
Investors miss price gains after maturity because there is no ownership of the underlying security.
Real example of a bullish digital option
Suppose that the Standard & Poor’s 500 (S&P 500) index trades at 2,795 on June 2. An investor believes that the S&P 500 will trade above 2,800 before the end of the trading day on June 4. The trader buys 10 S&P 500 options at an exercise price of 2,800 options for $ 40 per contract.
The S&P 500 closes above 2,800 at the end of the trading day on June 4. The investor is paid $ 100 per contract, which represents a profit of $ 60 per contract or $ 600 (($ 100 – $ 40) x 10 contracts).
The S&P 500 ends below 2,800 on June 4. The investor loses the entire premium amount or $ 400 (contracts of $ 40 x 10).
Real example of a bearish digital option
Suppose gold is currently trading at $ 1,251, and an investor believes that the price of gold will drop and close below $ 1,250 by the end of the day.
The investor sells a digital option for gold at an exercise price of $ 1,250 with expiration at the end of the day and will be paid $ 65 at maturity if it is correct. Since each of these digital options has a maximum value of $ 100, the premium paid in the event of loss will be $ 35 or ($ 100 – $ 65).
Gold prices drop and trade at $ 1,150 by the end of the day. The investor is paid $ 65 for the option.
The investor is wrong and the price of gold reaches $ 1,300 at the end of the day. The investor loses $ 35 or ($ 100 – $ 65 = $ 35).
It is important to note that Nadex digital options allow traders to exit certain positions before expiration for partial losses or profits depending on where the underlying is trading. However, there must be enough buyers and sellers available. In other words, liquidity – buying and selling of interest – must be present to close out an option position before maturity.