Digital Option

What is a 'Digital Option'

A digital option is an option whose payout is fixed after the underlying stock exceeds the predetermined threshold or strike price. It is also referred to as a "binary" or "all-or-nothing option." A digital option depends only on one proposition, which is whether the underlying asset expires in the money at the expiration date. If the underlying asset expires in the money, the option is automatically exercised.

BREAKING DOWN 'Digital Option'

Although digital options may appear to be simple, they are different from vanilla options and may be traded on unregulated platforms. Therefore, they may carry a higher risk of fraudulent activity. Investors who wish to invest in binary options should use platforms that are regulated by the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) or other regulators.

The value of the payout is determined at the onset of the contract and doesn't depend on the magnitude by which the price of the underlying moves. So, whether an investor is in the money by $1 or $5, the amount he receives will be the same. Since digital options are fairly simple to understand, this type of option may be more attractive than plain vanilla European or American options.

Digital Call Option

For example, imagine that the Standard & Poor's 500 Index (S&P 500 Index) is trading at 2,090 at 12:45 p.m., on June 2. A trader is bullish on the S&P 500 Index and believes that it will trade above 2,100 before the end of that trading day on June 2. The trader purchases 10 S&P 500 Index 2,100 cash-or-nothing call options on the S&P 500 Index at 12:45 p.m. for $50 per contract. If the S&P 500 Index closes above 2,100 at the end of the trading day, on June 2, the trader would receive $100 per contract, or a profit of $50 per contract. Conversely, if the S&P 500 Index closes below 2,100, the trader loses all of his investment, or $500.

Digital Put Option

Contrary to a digital call option, a digital put option is a bearish bet on an underlying security. For example, assume that a trader is bearish on the S&P 500 Index and believes it will close below 2,070 on June 2. At 12:45 p.m., the trader purchases 10 S&P 500 Index 2,070 cash-or-nothing put options for $30 per contract. If the S&P 500 Index closes below 2,070, the trader would profit $70, or $100 less $30, per contract. However, if the S&P 500 Index closes above 2,070, the trader receives nothing.

RELATED TERMS
  1. Cash-Or-Nothing Call

    An exotic option whose payoff is a predetermined amount (sometimes ...
  2. Cash-or-Nothing Put

    An exotic option whose payoff is a specified fixed price (sometimes ...
  3. Binary Option

    A type of option in which the payoff is structured to be either ...
  4. Index Option

    A financial derivative that gives the holder the right, but not ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  6. Put On A Call

    One of the four types of compound options, this is a "put" option ...
Related Articles
  1. Markets

    How to Make Money by Trading Index Options

    Index options are less volatile and more liquid than regular options. Understand how to trade index options with this simple introduction.
  2. Investing

    Types of Options

    There are many different types of options. In addition to general put options and call option, we will discuss 13 different types of options. Some of these option types are better suited to day ...
  3. Markets

    Want to Day Trade? Try Binary Options Or Spread Betting

    Interested in Day Trading? These two derivative products are growing in popularity due to their profit potential and small trading capital required.
  4. Trading

    A Guide To Trading Binary Options In The U.S.

    What binary options are, how they work and where you can legally trade them in the U.S.?
  5. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  6. Investing

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  7. Investing

    Index Options and Mini Index Options

    Index options allows a trader to wager on the movement of an entire stock market index, such as the Dow Jones or the S&P 500 index, rather than just an individual security.
  8. Trading

    Binary Options

    Binary options offer just two outcomes: all or nothing. Day trading with binary options can be easy and profitable resulting in high returns that are immediately paid out.
  9. Investing

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  10. Trading

    What You Need To Know About Binary Options Outside The U.S.

    Binary or digital options are a simple way to trade price fluctuations in multiple global markets.
RELATED FAQS
  1. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  2. What is the history of binary options?

    Discover the history of binary options trading, which is now one of the fastest growing investment market vehicles available ... Read Answer >>
  3. Do you have to be an expert investor to trade put options?

    Learn about investing in put options and the associated risks. Explore how options can provide risk, which is precisely defined ... Read Answer >>
  4. Does the seller (the writer) of an option determine the details of the option contract?

    The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between ... Read Answer >>
  5. Are put options more difficult to trade than call options?

    Learn about the difficulty of trading both call and put options. Explore how put options earn profits with underlying assets ... Read Answer >>
  6. What happens when a security reaches its strike price?

    Learn more about the moneyness of stock options and what happens when the underlying security's price reaches the option ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center