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Digital Option

Updated on April 11, 2024
Article byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Digital Option?

A digital option is an options trading type where the investors set a predetermined strike price for a security. Then they earn a profit if the asset’s market price exceeds the strike price before the expiration time. This trading option enables traders to make a fixed payout by accurately forecasting a security’s future market price.

Digital Option

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In digital options tradingthere are only two possible outcomes where the trader’s predictions are either true or false. When the traders make a correct prediction, they earn a profit they decided beforehand. However, if their prediction turns out to be incorrect, they lose the initial output.

Key Takeaways

  • A digital option is an option-type trading strategy where the investors can earn a fixed payout by accurately forecasting an asset’s future market price. 
  • The traders set a strike price and an expiration period for an asset. If the asset’s market price exceeds the strike price within the expiration period, the trader earns a profit which is decided in advance.
  • This trading option offers a maximum profit of up to 900%. The maximum losses traders can incur in this option is 100%. Additionally, traders can close the trade any time before the expiration time.

How Does A Digital Option Work?

A digital option is a trading option where traders can earn a fixed payout amount by correctly predicting an asset’s future market price. First, the investors choose an asset they want to invest in and pay the premium. Then they set the trade’s time and conditions, including the strike price and the expiration period. The investor earns a profit if the asset’s market prices exceed the strike price within the expiry period. However, if their prediction becomes incorrect, they lose the initial output.

In digital options trading, the investor loses the trade if the expiration time gets over with the strike price and the market price at the same level. The market prices must always exceed the strike. However, the difference between the strike and market prices does not impact the profit amount. Furthermore, investors can exit the position before the option expires if they feel the market price trends are not going according to their predictions.

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Features

This option features are as follows:

  • This option revolves around a currency pairing that has a brief lifespan.
  • Traders can incur a 100% maximum loss while trading with this option. However, they may earn a profit of as high as 900%.
  • Investors are usually attracted to the payoff variance of this option. However, a greater target implies a higher risk of incurring maximum losses.
  • A trader can close the trade any time before the expiration time. This move helps traders in augmenting their risk management strategies.

Trading Strategy

The digital options trading strategy is as follows:

#1 – Following The Trends

Traders commonly apply this strategy where they track the market price trends for the securities they want to invest in. Then, they set the strike price based on their analysis of the price trends.

#2 – Following The News

This strategy involves the traders following the news to determine how the market price trends are going to be. It also aids the traders in predicting the asset price which they are trading.

#3 – The Straddle Strategy

In this digital options trading strategy, the traders make straddle trades after any important news announcement or after a significant event. The security price may increase shortly after any critical event, but the traders must purchase an option that predicts the security price will fall again. When the security price starts to fall, the traders call a different option, hoping the price will rise again. This strategy allows the trader to utilize trend swings to earn profit.

Digital Option Payoff

There are two types of digital option payoffs — digital call option payoff and digital put option payoff. Let us look at each of them.

#1 Digital Call Option Payoff

In essence, a digital call option is a pact that gives entitlement to the holder to buy an underlying asset, for example, a stock at a specific strike in a particular timeframe. One can look at the following points to understand the payoff in this case.

  • A trader picks a financial asset, anticipating that its price will increase above a certain strike price before the conclusion of the option.
  • The individual fixes the investment amount and finalizes the expiration of the option.
  • Upon reaching expiration, in case the price of the underlying asset is above the strike price, the trader gets the prespecified payout. Otherwise, they lose their stake.

Let us look at the payoff diagram to get a clearer idea regarding this concept.

#2 Digital Put Option Payoff

In essence, a digital put option is a commitment bestowing the holder of the option the right to sell the underlying security at a specific strike price within the specified period. A digital option’s workings are as follows:

  1. First, a trader earmarks a financial asset, estimating the price will decrease under a fixed strike price before the culmination of the option. Besides the price, knowing the stock volume nuances provides one more layer of insight.
  2. After locking in the investment sum, the trader pins down the expiration of the option.
  3. At the time of expiration, in case the price of the asset lingers under the option’s strike price, the trader can claim the prespecified payout. Otherwise, the trader’s capital gets eroded.

Let us look at the following digital put option payoff graph to better understand the concept.

As one can observe, similar to digital call options, it features a binary outcome. Moreover, it depends on the price of the underlying asset at the time of expiry.

Examples

Let us understand the concept with the following examples:

Example #1

Suppose John is trading with gold. On a particular trading day, the market price of gold is $1400 at 12 pm. John believes that the gold price will rise on that day at 4 pm. So, he sets a strike price of $1500. However, at 4 pm, gold’s market price fell to $1200. As a result, John incurred a loss. This is one digital option example.

Example #2

Suppose Green is trading the shares of a company named Atlas Ltd. On a trading day, Atlas Ltd.’s securities’ market price was $800 at 1 pm. Green forecasted that at 2 pm, the company’s share price would increase, and she set the strike price at $1000. At 2 pm, the market price of Atlas Ltd.’s securities increased to $1250. Thus, Rose earned a profit. This is a digital option example.

Digital Option vs Vanilla Options vs One Touch Option

The differences are as follows:

  • Digital Option: In this option, the traders profit from accurately forecasting the security’s future market price. They set a strike price for the security and receive a payout if the asset’s market price exceeds the fixed strike price. The payout amount does not depend on how close the set strike price is to the market price.
  • Vanilla Option: The vanilla option is a simple put or call option with no particular expiration time or attributes. It offers the traders a time-limited opportunity to buy or sell a security at a pre-established price and receive a premium amount in exchange. The premium amount depends on several factors, which include how close the strike price is to the forward price, the security’s volatility, and the option’s maturity.
  • One Touch Option: In this option, the traders set a strike price for security above or below the security’s current market price. They also set an expiration time. Then the broker pays them an amount based on the trader’s selections. The trader receives a payout if the security’s market price hits the strike price at least once before the option’s expiry. The security’s market price does not require to exceed the strike price at the time of expiry. The payout amount depends on how far away the strike price is and the time till expiration. A strike price that is further away receives a higher payout. A longer expiration time leads to a lower payout because the traders get more time for the market price to hit their selected strike price.

Frequently Asked Questions (FAQs)

1. What are the benefits of digital options?

The benefits of this option are as follows:
– They can yield high profits 
– The trader can manage the risks
– This trading is easily accessible through a computer or a mobile device
– It requires low investments 

2. What is the difference between binary and digital options?

The difference between binary and digital option price lies in the strike price and expiration time. The strike price and expiration time are pre-established in binary options when the trade begins. In digital options, traders can exert more control over these factors. Furthermore, in this option, traders can select their profit or loss percentage on any trade, which is not an option they receive in a binary options trade.

3. What is the difference between an option and a digital option?

The difference between an option and a digital option price is that in the digital option, the trader receives the same amount irrespective of the gap between the security’s strike price and its market price. The degree by which the security’s price rises more than the strike price in the call option or falls in the put action does not impact the amount the trader receives. However, an option turns significantly valuable if the security’s value becomes ten times more expensive.

This article has been a guide to what is Digital Option. Here, we explain its trading strategy, examples, comparison with one touch option, and features. You may also find some useful articles here –

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