Digital Option

What is a Digital Option?

A digital option is a type of option that pays out a preset amount if the actual market price exceeds a set limit called the special price. Investors can profit from precise estimates of an asset's future price by trading these options. 

Investors can assess the likelihood of an event occurring before the option expires based on affirmative or negative outcomes.

Traders can manually adjust the strike price. This option pays out a defined amount to traders if the underlying asset's market price surpasses the strike price. Manual strike price adjustment can potentially manage trading risk and increase potential benefits.

You can either buy or sell contracts while trading these options. You would buy if you believed the market would rise over your chosen strike price. It's comparable to purchasing a call option. 

Sell if you believe the price will decline below the strike price. It's comparable to purchasing a put option. 

There are just two possible outcomes: accurate or inaccurate. Thus, it doesn't matter how far the market moves (up or down) the strike price. In other words, the maximum possible profit or loss is established before the trade is entered.

These upper limits vary depending on the premium you pay, the size of the order, the strike price, and the length of the contract, among other things.

Digital options enable trading in various financial assets. Digital options provide traders and investors with forecasts of the future value of assets, albeit not always precise.

They give traders two possible outcomes for any trade: either make money if forecasts are accurate or lose it if they are wrong. 

Working of a Digital Option

Digital options operate by providing two potential outcomes for every particular trade: if your forecast is accurate, you make money. However, you forfeit your initial output if you’re wrong. 

You would determine whether you believe the price of your chosen market is going up or down before initiating a trade. You will purchase a call digital option if you think it would increase. You will purchase a put if you anticipate a decline. 

When the option expires, calls produce a profit if the underlying market’s price exceeds the strike price. Puts are the contrary; they make money if the underlying market’s price is lower than the strike price when the option expires.

Each of these options combines characteristics of a standard option, a binary option, and a one-touch option. Traders can modify the probable profit margin by altering the strike price. Trading risk can be lessened if traders set the strike price near the current market price.

While the option is still open, traders can speculate on the likelihood that an event will occur based on statements with yes or no as the two possible values. Trades are typically short-term, with expiration periods ranging from minutes to days.

Trades can be closed off whenever before the expiration period, allowing traders to lock in profits and reduce losses. 

The traders make the asset, expiration time, and investment amount. Users choose the strike price and click CALL if they think the asset's price will rise or PUT if they think it will fall. The traders can then sell the option before it expires or wait until it has expired. 

This option can be traded in increments of $1 and $20,000. Also, traders must pay a premium upfront, capped at $100. The premium represents the upfront cost of the option and is the maximum amount a trader can lose if the option expires out of the money.

A digital option can only be exercised when the true price differs from the strike price. So, a put option must be below the strike price by at least one percent in point (pip) to be exercised.

Features of a Digital Option

Some of the features are:

Should I Report Digital Options?

Due to the lack of standardization in strike price and expiration date, participants often customize their terms in over-the-counter (OTC) derivative options traded off-exchange to provide traders more flexibility.

These instruments are subject to the regulator's obligation for OTC derivative reporting because there is no secondary market for the product categories. Due to the global nature of trading in these options, financial firms engaging in this market may be subject to reporting requirements.

Here is how you can facilitate a report:

1. Choose A Broker: A broker provides access to the market for traders. Traders should check if they offer the necessary tools, like a signals service, mobile app, or demo account, and ensure a reputable body governs them. Account rules, such as minimum deposit requirements, may also be in force.
2. Choose the Asset: The options can be exchanged using a range of assets, including but not limited to gold and foreign currency.
3. Set The Parameters: The parameters will be determined by the analysis and trading plan of the market. Hedging digital options through a call spread, in which a call is purchased at one strike and sold at a higher strike, illustrates these techniques. Another analysis method is computing the delta, a trading risk indicator that considers the ratio between the price of the underlying asset and the change in the option's price. 
4. Sit Tight: After entering your position, wait patiently for your asset to reach the strike price or expire. Some digital options brokers allow traders to exit a position early if the outcome seems unfavorable, potentially avoiding losses.

Digital Options Types

There are various types of digital alternatives, each with its unique purpose. As a result, these categories differ based on the asset type. Below are some examples of the various sorts of this option.

1. Ladder-style: Give traders a chance to lock in profits if the price reaches "tiers," or intermediate points between the strike and current prices. This reduces the risk associated with trading options, which can be particularly helpful when anticipating price movements but uncertain about their direction
2. Up/Down: When the contract expires, a trader predicts whether the asset price will be above or below a specific mark (the strike price)
3. One-Touch: If the asset price meets the strike price at any time before the expiration period, the trader will earn a payout
4. Target options: Two spot prices are selected, and the trader receives a payout if the price remains within the specified range until expiration. These are also known as dual digital options
5. Hi/Lo: When traders are certain about an asset's volatility, they anticipate the range for the market's daily high or low
6. Tunnel: These options are similar to target options, where upper and lower strike prices are set, but the trader earns a payout only if the asset remains within the tunnel, never touching either strike price

Example of a Digital Option

While trading digital options, the investor deliberately sets a price that they anticipate an asset will reach within a specified time frame; this price may be greater or lower than the one used for trading.

The broker evaluates the likelihood of the asset reaching the strike price by assigning a value between 0 and 100 to the option. Brokers consider asset volatility and time to expiration when calculating option prices. A digital 100 has become another term as a result. 

The profit or loss for the trader is determined by the difference between the asset's closing price and the strike price, multiplied by the stake per point.

As an illustration, the trader wagers $1 per point fluctuation at the quoted price of $70. At the expiration time, if the price is $70, the profit would be

(100 - 70) x $1 = $30

The trader would forfeit (70 - 0) x $1 = $70 if the price did not reach $70 at the expiration date. 

Because potential losses in these options trading are always greater than potential gains, the trader must have more proper options than incorrect options to generate a profit overall.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• American vs European vs Bermudan Options
• Currency Option
• Derivatives
• Exotic Options
• Options: Calls and Puts