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.

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