What Is a Digital Option?
A digital option is a type of options contract that has a fixed payout if the underlying asset moves past the predetermined threshold or strike price. There's an upfront fee called the premium for digital options, which is the maximum loss for the option.
Unlike traditional options, digital options don't convert or exercise to the underlying asset's shares. Instead, they pay out a fixed reward if the asset's price is above or below the option's strike price. Digital options are also referred to as a "binary" or "all-or-nothing options."
Options are financial derivatives, so they receive their value from an underlying asset or security. Traditional options give buyers the ability, though not the obligation, to transact in the underlying security at a predetermined price—called the strike price—by date of expiration—or the end date of the contract.
Options have a premium attached to them, meaning they have an upfront fee. The premium can fluctuate over time and vary from option-to-option based on the value of the underlying security, how close the option is to its expiration, the strike price, and the level of demand for the option in the market.
The value of the premium can also provide insight as to value investors place on the option and the underlying security. An option that has value will likely have a higher premium than an option that is unlikely to make a profit by its expiry date. Options are available for many securities including equities, currencies such as the euro, and commodities such as crude oil, corn, and natural gas.
- Digital options are a type of options contract that has a fixed payout if the underlying asset moves past the predetermined threshold or strike price.
- The upfront fee called the premium is the maximum loss for digital options.
- Unlike traditional options, digital options don't convert or exercise to the shares of the underlying asset.
Unique Features of Digital Options
Digital options are different from traditional options in that they don't transfer ownership of shares when exercised or at their expiration date. Instead, digital options pay out the fixed amount to the investor if the price of the underlying security is above or below the strike of the option at expiry. 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.
If the underlying asset expires in-the-money, meaning the option is profitable, the option is automatically paid out with the trader receiving the profit. If the option expires out-of-the-money meaning it's not profitable, the investor's maximum loss is limited to the upfront premium regardless of the underlying's price movements.
A digital option is merely a gamble or a bet that the price of the underlying asset will be above or below the strike price at a certain time and date. If an investor believes the price of the underlying will be above the strike, the option will be purchased. Conversely, if an investor believes the underlying's price will be below the strike, the option will be sold.
Listing and Regulation of Digital Options
Unlike vanilla options, selling a digital option does not mean the trader is writing an option, which involves the seller or writer being paid a fee for allowing the buyer to exercise the option. In most cases, investors who sell traditional options use them as an income strategy and hope the option will not be exercised so they can keep the premium.
Selling a digital option is equivalent to buying a put option whereby the investor expects the underlying to be below the strike price at expiry. Some digital options brokers break up these options into calls and puts, whereas others have only one option where traders can buy or sell—depending on which direction they expect 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's price is expected to fall.
Digital options may appear to be similar to standard options contracts, but they may be traded on unregulated platforms. As a result, digital options can 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) and the Commodity Futures Trading Commission (CFTC).
Nadex is a regulated digital options broker in the U.S. The platform provides strike prices and expirations for various underlying assets. All options have a value of $100 or $0 at expiry. The maximum payout 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 payout is also $50 because each contract's maximum value is $100. If the premium is $30, the maximum payout is $70 for that option.
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.
Digital options pay a fixed amount if the underlying asset moves past the predetermined threshold or strike price.
The maximum loss for digital options is limited to the upfront fee or premium.
Unlike traditional options, digital options don't convert or exercise to the underlying asset's shares.
Digital option's profits are limited to the fixed payout.
Digital options can be risky if traded on unregulated platforms.
Investors miss out on price gains after expiry since there's no ownership of the underlying security.
Real World Example of a Bullish Digital Option
Let's say the Standard & Poor's 500 Index (S&P 500) is trading at 2,795 June 2. An investor believes the S&P 500 will trade above 2,800 before the end of the trading day June 4. The trader purchases 10 S&P 500 options at a strike price of 2,800 options for $40 per contract.
The S&P 500 closes above 2,800 at the end of the trading day, June 4. The investor is paid $100 per contract, which is a profit of $60 per contract or $600 (($100 - $40) x 10 contracts).
The S&P 500 closes below 2,800 June 4. The investor loses all of the premium amount or $400 ($40 x 10 contracts).
Real World Example of a Bearish Digital Option
Let's say gold is currently trading at $1,251, and an investor believes the price of gold will decline and close below $1,250 by the end of the day.
The investor sells a digital option for gold at a $1,250 strike price with expiry at the end of the day and will be paid $65 at expiry if correct. Since each of these digital options have a maximum value of $100, the premium paid in the event of a loss will be $35 or ($100 - $65).
Gold's price falls and is trading at $1,150 by the end of the day. The investor is paid $65 for the option.
The investor is wrong, and gold's price surges to $1,300 by the end of the day. The investor loses $35 or ($100 - $65 = $35).
It's important to note that Nadex digital options allow traders to exit some positions before expiry for partial losses or partial profits depending on where the underlying is trading. However, there needs to be enough buyers and seller available. In other words, the liquidity—buying and selling interest—needs to be present to unwind an option position before expiry.