Comparison of option types (5) – Digital Options

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Comparison of option types (5) – Digital Options

There are numerous types of binary options offered by brokers for trading: Touch options and No-Touch options, traditional medium-term up/down options offered by all brokers, ladder options and much more.

Every trader must answer the same questions: “Which of the options are the best for trading? Why choose a broker based on the type of options and expiry time?” In our today’s article, we are going to explore in depth digital options, which is, in fact, nothing else than a fancy name for ladder options.

Digital binary options by IQ Options

This is a type of options in which the trader determines the strike price, which is the key to the achievement of the potential profit. Same as the ladder binary options, digital options (btw. IQ Option is the only broker in the market to offer this type of options) are somewhat more complicated to understand than other types of options. Therefore I will do my best to explain this in simple terms. Let’s start with a picture.

As you can see in the picture, it is the trader who sets the strike price – like in a ladder

The picture shows the concept of digital options trading. The trader again speculates over the future price development, same as with normal binary options. This time the strike price is not limited. Therefore, the trader can choose which one he or she wants to use.

How do the digital options work?

Let’s take one more look at the picture. What we can see is the following:

  • The current price of the asset in the picture is 1.12625
  • The prices on the left hand side are as follows: 1.1267, 1.1266, 1.1265 etc.
  • When you click on the different price buttons, a different percentages (your profit) shows up

When trading digital options, it is the trader who selects from a few pre-set strike prices the one he or she wishes to use. Speculations are over the final price (…is it going to be higher or lower than the strike price?). The current closing price of a trade predetermines the future profit from the trade.

Example of trading CALL when trading ladder options (size of trade: $100)

The example in the picture shows the way it all works. (Though the picture depicts LADDER options, in reality the process is the same).

Let’s assume that the picture is a real graph. After opening a trade worth $100 upward (shown on the ladder on the right) we can see that the profit grows proportionally with the risk. We will earn more if we believe that the price is in a strong uptrend and, before reaching the expiry date, has grown much higher.

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Video: Trading of digital options

I am going to outsmart them!

Some of you may say: “Well, I am going to set the lowest strike price there is, because the chances that the price falls so low are minimal! This way I will never lose!”

Well, you are right. BUT…you must take into account that with nearly 100% certainty to win, the final profit will not be breathtaking. A trade like this may generate a profit of around 5%. This means that your profit from a USD 100 investment will be merely USD 5. Given that what you put at stake is worth USD 100, this does not appear to be fair.

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Advantages of this type of binary options

  • With digital options you can achieve astronomic returns (more than 300% profit)
  • Using reasonable judgement with a little luck in some cases you cannot lose (supposing you use efficient hedging)
  • Unlike ladder options offered by other traders, with digital options from IQ Option you can sell the option within the expiry time to either boost the profit (in case of a successful trade) or moderate the loss (in case of bad luck).

Disadvantages of this type of binary options

  • On the other hand, highly rated options are highly risky.
  • This type of trading is more difficult to comprehend. Therefore it is not suitable for novices.

Watch our video tour of IQ Option

More information

  • Official statements about digital options: https://blog.iqoption.com/en/digital-options-introducing-a-new-trading-tool/
  • Review of IQ Option
  • Review of IQ Option (in Slovak)
  • Review of IQ Option (in English)
  • Review of IQ Option (in Polish)
  • Review of IQ Option (in Swedish)

Author

More about the author J. Pro

Unlike Stephen (the other author) I have been thinking mainly about online business lately. I wasn’t very successfull with dropshipping on Amazon and other ways of making money online, and I’d only earn a few hundreds of dollars in years. But then binary options caught my attention with it’s simplicity. Now I’m glad it did because it really is worth it. More posts by this author

8 Responses to “Comparison of option types (5) – Digital Options”

Hello, can we help you somehow?

i think if you have experience of news trading so digital option is the one of the best trading way for you.

I think there are 99 % chances of our winning here with our luck if we select the lowest strike although we will get the lower profit but we will not lose i am going to try this someone recommend me is it good to start with digital option?

Abdul, sometimes, the price can move very rapidly in the wrong direction. Be careful! But good luck.

Yeah it is true i have seen it on practice account that the price increase rapidly but as compared to binary options it is 1000 times better as we can get some profit.. In binary there is pure gambling so am i right? ?

I actually do this, but only when I have a trade that I’m already winning. For example if the price of an istrument is 100 when you start and I bought an OTM option with a strike at 103 and now the price is 105, I’d bought another with a 99 strike. I’ll also cover my bets buying an option in the oposite direction that could be smaller if it’s an OTM or bigger if it’s an ITM. Time, Risk and probabilities are key when trading digital options. The safest way to start is to only buy OTM’s with smaller sizes and big returns. For this I’ll use a standard 5min candlestick chart and a 1 min chart…to get the timing right.

Also…and this is for the pros that might read this. If you’re trading EURUSD, you can watch the futures (6E) footprint chart to asses key risk areas in the 1min timeframe. This will give you a better idea of risk and probability given that you could succesfully identify absortion levels.

With iQoption you can put a trade for the next 5min, 30 sec before the current bar is over….if you trade futures already when you see this is like watching free money.

I’ll advise that newbies trade at lest for 3months on the demo account or until they can get consistent risk adjusted returns. If not there is a 99.9% you’ll loose all of your capital.

Types of Options

There are many different types of options that can be traded and these can be categorized in a number of ways. In a very broad sense, there are two main types: calls and puts. Calls give the buyer the right to buy the underlying asset, while puts give the buyer the right to sell the underlying asset. Along with this clear distinction, options are also usually classified based on whether they are American style or European style. This has nothing to do with geographical location, but rather when the contracts can be exercised. You can read more about the differences below.

Options can be further categorized based on the method in which they are traded, their expiration cycle, and the underlying security they relate to. There are also other specific types and a number of exotic options that exist. On this page we have published a comprehensive list of the most common categories along with the different types that fall into these categories. We have also provided further information on each type.

  • Calls
  • Puts
  • American Style
  • European Style
  • Exchange Traded Options
  • Over The Counter Options
  • Option Type by Expiration
  • Option Type by Underlying Security
  • Employee Stock Options
  • Cash Settled Options
  • Exotic Options

Calls

Call options are contracts that give the owner the right to buy the underlying asset in the future at an agreed price. You would buy a call if you believed that the underlying asset was likely to increase in price over a given period of time. Calls have an expiration date and, depending on the terms of the contract, the underlying asset can be bought any time prior to the expiration date or on the expiration date. For more detailed information on this type and some examples, please visit the following page – Calls.

Put options are essentially the opposite of calls. The owner of a put has the right to sell the underlying asset in the future at a pre-determined price. Therefore, you would buy a put if you were expecting the underlying asset to fall in value. As with calls, there is an expiration date in the contact. For additional information and examples of how puts options work, please read the following page – Puts.

American Style

The term “American style” in relation to options has nothing to do with where contracts are bought or sold, but rather to the terms of the contracts. Options contracts come with an expiration date, at which point the owner has the right to buy the underlying security (if a call) or sell it (if a put). With American style options, the owner of the contract also has the right to exercise at any time prior to the expiration date. This additional flexibility is an obvious advantage to the owner of an American style contract. You can find more information, and working examples, on the following page – American Style Options.

European Style

The owners of European style options contracts are not afforded the same flexibility as with American style contracts. If you own a European style contract then you have the right to buy or sell the underlying asset on which the contract is based only on the expiration date and not before. Please read the following page for more detail on this style – European Style Options.

Exchange Traded Options

Also known as listed options, this is the most common form of options. The term “Exchanged Traded” is used to describe any options contract that is listed on a public trading exchange. They can be bought and sold by anyone by using the services of a suitable broker.

Over The Counter Options

“Over The Counter” (OTC) options are only traded in the OTC markets, making them less accessible to the general public. They tend to be customized contracts with more complicated terms than most Exchange Traded contracts.

Option Type by Underlying Security

When people use the term options they are generally referring to stock options, where the underlying asset is shares in a publically listed company. While these are certainly very common, there are also a number of other types where the underlying security is something else. We have listed the most common of these below with a brief description.

Stock Options: The underlying asset for these contracts is shares in a specific publically listed company.

Index Options: These are very similar to stock options, but rather than the underlying security being stocks in a specific company it is an index – such as the S&P 500.

Forex/Currency Options: Contracts of this type grant the owner the right to buy or sell a specific currency at an agreed exchange rate.

Futures Options: The underlying security for this type is a specified futures contract. A futures option essentially gives the owner the right to enter into that specified futures contract.

Commodity Options: The underlying asset for a contract of this type can be either a physical commodity or a commodity futures contract.

Basket Options: A basket contract is based on the underlying asset of a group of securities which could be made up stocks, currencies, commodities or other financial instruments.

Option Type By Expiration

Contracts can be classified by their expiration cycle, which relates to the point to which the owner must exercise their right to buy or sell the relevant asset under the terms of the contract. Some contracts are only available with one specific type of expiration cycle, while with some contracts you are able to choose. For most options traders, this information is far from essential, but it can help to recognize the terms. Below are some details on the different contract types based on their expiration cycle.

Regular Options: These are based on the standardized expiration cycles that options contracts are listed under. When purchasing a contract of this type, you will have the choice of at least four different expiration months to choose from. The reasons for these expiration cycles existing in the way they do is due to restrictions put in place when options were first introduced about when they could be traded. Expiration cycles can get somewhat complicated, but all you really need to understand is that you will be able to choose your preferred expiration date from a selection of at least four different months.

Weekly Options: Also known as weeklies, these were introduced in 2005. They are currently only available on a limited number of underlying securities,including some of the major indices, but their popularity is increasing. The basic principle of weeklies is the same as regular options, but they just have a much shorter expiration period.

Quarterly Options: Also referred to as quarterlies, these are listed on the exchanges with expirations for the nearest four quarters plus the final quarter of the following year. Unlike regular contracts which expire on the third Friday of the expiration month, quarterlies expire on the last day of the expiration month.

Long-Term Expiration Anticipation Securities: These longer term contracts are generally known as LEAPS and are available on a fairly wide range of underlying securities. LEAPS always expire in January but can be bought with expiration dates for the following three years.

Employee Stock Options

These are a form of stock option where employees are granted contracts based on the stock of the company they work for. They are generally used as a form of remuneration, bonus, or incentive to join a company. You can read more about these on the following page – Employee Stock Options.

Cash Settled Options

Cash settled contracts do not involve the physical transfer of the underlying asset when they are exercised or settled. Instead, whichever party to the contract has made a profit is paid in cash by the other party. These types of contracts are typically used when the underlying asset is difficult or expensive to transfer to the other party. You can find more on the following page – Cash Settled Options.

Exotic Options

Exotic option is a term that is used to apply to a contract that has been customized with more complex provisions. They are also classified as Non-Standardized options. There are a plethora of different exotic contracts, many of which are only available from OTC markets. Some exotic contracts, however, are becoming more popular with mainstream investors and getting listed on the public exchanges. Below are some of the more common types.

Barrier Options: These contracts provide a pay-out to the holder if the underlying security does (or does not, depending on the terms of the contract) reach a pre-determined price. For more information please read the following page – Barrier Options.

Binary Options: When a contract of this type expires in profit for the owner, they are awarded a fixed amount of money. Please visit the following page for further details on these contracts – Binary Options.

Chooser Options: These were named “Chooser,” options because they allow the owner of the contract to choose whether it’s a call or a put when a specific date is reached.

Compound Options: These are options where the underlying security is another options contract.

Look Back Options: This type of contract has no strike price, but instead allows the owner to exercise at the best price the underlying security reached during the term of the contract. For examples and additional details please visit the following page – Look Back Options.

Digital Option

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 Explained

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.

Key Takeaways

  • 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.

Scenario 1:

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).

Scenario 2:

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).

Scenario 1:

Gold’s price falls and is trading at $1,150 by the end of the day. The investor is paid $65 for the option.

Scenario 2:

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.

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