What is a Digital Option
A digital option has a fixed payout if the underlying asset moves past the predetermined threshold or strike price. The loss is also fixed if the underlying asset doesn't move past the threshold. A digital option depends on one proposition, which is whether the underlying asset expires in the money at the expiration date and time. If the underlying asset expires in the money, the option is automatically paid out with the trader receiving the profit or the loss being logged in the account. Digital options payout profits, but are not exercised like vanilla options which provide the potential for ownership of the underlying.
It is also referred to as a "binary" or "all-or-nothing option."
Breaking Down the Digital Option
Digital options may appear to be simple, but 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 trade digital 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, and the potential loss, is determined at the onset of the contract and doesn't depend on the magnitude by which the price of the underlying moves. The premise of a digital option is that the price of the underlying asset must be above or below a specified price (strike price) at a certain time and date. If the trader believes the price of the underlying will be above the strike, they buy the option. If they think the underlying will be below the strike, they sell the option.
Unlike vanilla options, selling a digital option doesn't mean the trader is writing an option, Rather, selling a digital option is equivalent to buying a put; the trader is anticipating the underlying will be below the strike price at expiry. Some digital option brokers break up these options into calls and puts, whereas others have just one option where traders can buy or sell (depending on which direction they think the price will go). Call options are bought when the price of the underlying is expected to rise. Put options are bought when the underlying is expected to fall.
Bullish Digital Option Example
Nadex is a regulated digital options broker in the U.S. The platform provides strike prices and expirations for various underlying assets. Traders buy the option if they think the price of the underlying will be above the strike at expiration. If they think the underlying will be below the strike, they sell the option. All options have a value of $100 or $0 at expiry.
For example, the Standard & Poor's 500 Index (S&P 500 Index) is trading at 2,795 on June 2.
A trader is bullish on the S&P 500 Index and believes that it will trade above 2,800 before the end of the trading day on June 4. The trader purchases 10 S&P 500 Index 2,800 options for $40 per contract.
If the S&P 500 Index closes above 2,800 at the end of the trading day, on June 4, the trader receives $100 per contract, which is a profit of $60 per contract or $600 (($100 - $40) x 10 contracts). Conversely, if the S&P 500 Index closes below 2,800 on that day, the trader loses all their investment, or $400 ($40 x 10 contracts).
Bearish Digital Option Example
Assume another trader is bearish on gold. Gold is currently trading at $1,251 and the trade believes gold will close below $1,250 by the end of the day. The trader sells a 1,250 gold digital option with an expiry at the end of the day. They sell the option at $65. This means if the underlying does close below $1250, they make $65, since the option is now worth $0 and they sold it for $65. If the underlying is above $1,250 at expiry, the option is worth $100 so the trader loses $35 since they sold it at $65.
Nadex digital options allow traders to exit positions before expiry for partial losses or profits.