Digital Options Explained

What is a Digital Option? 

A digital option enables a trader to predict whether a statement about a given financial market, underlying asset, commodity, or currency pair is true or false. Hence, there are only two possible outcomes: yes or no. 

Digital options are based on a single statement, implying if a trader correctly predicts a specific market event, he or she generates a profit. Contrarily, if the prediction is wrong, the trader incurs a loss and loses his/her initial capital, which is referred to as the premium. 

For instance, let us say the digital option statement indicates ‘Gold price will increase.’ If you consider this to be correct (true), you can buy the digital option. This is known as a ‘call option,’ allowing a trader the right to buy.  

Alternatively, if you think the statement is untrue, you have the choice to sell. This is referred to as a ‘put option,’ giving a trader the right to sell.  

Similar to other types of options, the potential payout on a specific digital option contract is calculated with a specific strike price in mind. The strike price is manually set, helping to minimise the risk associated with trading. 

Factors determining the potential pay-out of a digital option trade are, amongst others: the distance of the strike price from the current market price and the level (above, below, or at the same level) of the strike price in relation to the current market price.  

In a digital option trade, the maximum potential profit or loss is determined before the trade is placed. Thus, It does not matter how far above or below the strike price the market price moves during the contract duration, because it is the predicted outcome (correct or incorrect) that counts.    

The maximum profit or loss depends on factors such as the strike price, the premium paid, the order size, and the contract duration. 

A digital option is also referred to as a one-touch option, a fixed return option, a bet option, all or nothing option, and in some instances a digital 100.  

What is the difference between American-style digital options and European-style digital options?  

• American-style options refer to digital options where the pay-out happens whenever the asset price/market price hits the strike price. 
• European-style options result in a pay-out on the strike date. 

The history of Digital Options 

The trading of digital options has been executed for more than thirty years. Although, before 1973, they were only available in closed markets and usually a small part of some trading platforms.  

Nowadays, digital options are available on a global scale on numerous trading platforms. One of the major role players initiating this remarkable improvement was the Chicago Board Options Exchange (CBOE) which was established by the Chicago Board of Trade in 1973. 

The CBOE started the authorisation, allowing digital options to become over-the-counter trading instruments. Although not standardised at that time, the authorisation allowed digital options trading to be included in trading platforms. 

The lack of regulations and oversight hampered digital options trading for a considerable period of time. This has changed with the establishment of the Options Clearing Corporation (OCC) in Chicago in 1973. As a central clearinghouse and regulator, the OCC has enabled this form of trading to conquer challenges by applying measures such as: 

• Clearer instructions. 
• A higher level of transparency. 
• Set guidelines for trader conduct. 
• Traders who traded in unethical ways were temporarily suspended or permanently banned from trading platforms. 

Despite significant improvements in the trading of digital options, they were still a small segment of the trading instruments available. The major breakthrough for digital options came in 2008 when the Securities and Exchange Commission (SEC) in the USA accepted the proposals submitted by the OCC, allowing major stock markets to offer digital options. 

The American Stock Exchange (AMEX) (currently known as the NYSE American) was the first stock exchange which allowed digital options trading. The CBOE followed soon to offer them publicly. During the past few years, digital options have become a very popular trading instrument and are nowadays widely traded all over the world to generate income for traders and investors. 

Analysts indicate various reasons why digital options trading has become so popular. For instance: 

• The regulations were implemented in 2008. 
• Improved technology, allowing traders to conduct trades via online platforms on computers and laptops, and even smartphones and tablets. 
• There is no need to download a specific program. 
• Transparency of the trading system, reducing speculation. 
• Improvements implemented by brokers and the need to address the needs of investors and traders. For example, improved trading platforms, increased customer service, more trading tools available to traders, and availability of real-time financial data. 

Types of Digital Options 

There are various types of digital options available. However, traders differ about the number of types available, ranging between four and six types. The four types described below are considered the four distinct types of digital options trading. 

• Ladder 

This type enables traders to lock in partial profits if the price reaches intermediary levels – referred to as ‘rungs’ – to the strike price (exercise price). This strategy reduces the risk involved in digital options trading and is especially applicable when a trader expects the price will move but is unsure of the direction.  

For example, a trader would buy if he/she thinks the exercise price will exceed his/her predicted price. Conversely, a trader would sell if he/she thinks the settlement price will drop below his/her strike price.  

• One-Touch 

One-Touch digital options allow a trader to generate a profit depending on whether the settlement price will hit the strike price or not at any point before the digital option expires. If the answer is yes, the trader will buy. If the outcome is negative, the trader will sell. 

• Up/Down 

 In this type, there is only one strike price applicable, namely the preceding trading period’s closing price. A trader takes a position based on whether the settlement price will be above or below the closing price of the previous period at the time the digital option expires. 

• Range 

Range digital options are a type of digital option where a trader must decide whether the settlement price will be within a certain range when the digital option expires. 

How to trade a Digital Option 

Trading digital options are relatively uncomplicated. However, you still need to follow a few basic steps to successfully trade on financial markets.  

Step #1 – Select a broker 

A broker provides retail traders access to financial markets to trade digital options. Make sure the broker is regulated with a reputable and credible authority. Ask questions, amongst others, about trading tools required, demo accounts, trading account rules, and minimum deposits required. 

Step #2 – Choose a type 

Choose one of the four digital option types which is described above.  

Step #3 – Select an asset/market 

Digital options can be traded with various assets (such as gold or platinum), currency pairs, and indices of financial markets. The liquidity and volatility of the products mentioned will influence potential payouts. 

Consider how available relevant data is.  

Step #4 – Set a strike price 

Choose a strike price and decide whether you want to buy or sell. Set parameters, based on analysis and your trading strategy.  

Step #5 – Practice on a demo account 

Typically, professional brokers provide demo accounts, allowing retail traders to practice their trading strategies before they start to trade with real money. This strategy helps to minimise the risk of losing money. 

Step #6 – Enter your position 

Determine your trade size, based on how much you could potentially lose. Place your order on whether you believe your prediction will happen (buy) or will not happen (sell). 

Step #7 – Monitor your position 

Sit tight and monitor your position. You should be able to follow your position on a chart. At some digital options brokers, it will be possible to exit your position or reduce your position size if the outcome appears to be unfavourable to you. This will help to limit losses. 

Regulation of Digital Options 

Digital options are strictly regulated in some countries and are banned for retail traders in certain countries. 

In the USA, the trading of digital options is only allowed on the following regulated exchanges: the Chicago Mercantile Exchange, the Cantor Exchange, and the North American Derivatives Exchange (Nadex). 

Examples of Digital Option trading 

• Example #1 (Gold as an asset with a put option) 

It is Monday at 11:30 in Johannesburg, South Africa. At the moment, gold is trading at $1 770 per ounce. A trader expects that the gold price will close at a level of less than $1 770 per ounce on the specific trading day. 

Hence, the trader executes a put option at the strike price of $1 720 with an expiration at the end of trading on Monday. If the gold price decreases below $1 770, the trader’s prediction is correct, and he/she will receive a return on the money spent. However, if the gold price remains $1 770 per ounce or increases, the trader will incur a loss. 

• Example #2 (Gold as an asset with a call option) 

Same day, time, place, and gold still trading at $1 770 per ounce. However, the trader believes that by 15:30 on Monday, gold will have increased in value, exceeding the price of $1 770 per ounce.  

The trader decides to buy a call option with a strike price of $1 800 and a timeframe that expires at 15:30 on Monday. If the trader’s prediction is correct, and the price of gold is above $1 800 per ounce at 15:30, the trader will gain a profit on the trade. Conversely, if the value of gold decreases below $1 770 at 15:30, the trader will make a loss. 

Benefits of Digital Options 

Trading digital options provide a variety of benefits, including: 

• Simplicity limits the number of outcomes. The result can only be a yes or no. 
• Accessibility allows a trader to execute digital options trades on trading platforms on desktop computers, laptops, tablets, or smartphones, enabling trading at specific locations or while on the move. 
• Minimising risk – Traders are aware of what their potential profit or loss will be before placing a trade. Also, hedging can be used to counterbalance some of the risks. 
• Substantial profits can be made from correct predictions, even within short timescales. 
• Favourable timeframes allow traders to take positions on some of the most influential exchanges in the world, starting from as little as one to five minutes. 
• Trading opportunities – Traders have the advantage of trading when markets are moving sideways, enabling them to generate profits during periods of low volatility. 
• Traders can trade in a wide variety of financial instruments.  

Risks of Digital Options 

Notwithstanding all the benefits offered by digital options, there are also certain risks involved in trading digital options. For instance: 

• Potential losses – If your prediction is wrong, you lose your upfront fee (premium). In addition, sharp market swings during periods of volatility can cause considerable losses. 
• Limitations for retail traders – Digital options trading is prohibited for retail traders in numerous countries. (Retail traders, also called individual traders, are defined as traders who buy or sell securities for personal accounts.)  
• Complicated risk prediction – Trading on short timeframes can make it difficult to consistently predict market movements. 

Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional, regulated, and recommended broker before making trading and investment decisions.