What to Know about a Digital Option

Digital options are also called binary options. Digital options come in two varieties; the European and the American. Just like normal options, the values of digital options are based on the values of the underlying assets. The underlying assets can be stocks, shares, bonds, insurance or currency. With digital options you bet on the movement of the underlying asset by the strike date. You choose a call option if you believe that the underlying asset will rise in value and a put option if you believe the underlying asset will lose value.

Single Payout

In digital options you receive a payout if the underlying asset trades at or above a previously determined rate by a certain date called the strike date. You have only two potential returns – either you receive the payout or you do not. There is no option of a low return or a very high return. The value of the payout is predetermined. It does not matter if the underlying stock or asset moves up very high or not.

Exotic Option

A digital option is an example of an exotic option. It is used in stocks, bonds, and mortgage backed securities. Just like ordinary options, you can leverage your knowledge of the market of the underlying asset by trading in digital options.

Most digital options are European style ones as they yield results on the particular strike date. American style digital options are exercised whenever the price touches the strike price before the expiry of the contract. As such the returns they offer are calculated differently from the European style options.

Cash-or-Nothing Options

These are digital options where the winner of the call position gets a fixed, pre-determined amount of cash if the strike price is reached by the strike date.

Asset-or-Nothing Options

These are digital options where the person taking the call or put position gets the underlying asset or nothing depending on whether the strike price is reached by the strike date or not.

Low Investment, High Returns

As the investment required for options is lower than that required for buying the underlying asset, it is possible to get high returns from low investments in the digital options market. All you have to decide as an investor is whether the market for the underlying asset will be bullish or bearish before the strike date and the price of the underlying asset on the strike date.

You will either lose the entire investment, or make a killing on the investment. There is no middle-ground with a digital or binary option.

Unlike plain vanilla options, a digital option forces you to be more precise in your prediction of the value of the underlying asset. If you have a call position, for instance, in an ordinary option you will make some money if the value of the underlying asset rises even a bit. However, in a digital option you will make money only if the underlying asset reaches your strike price by the strike date. Though this makes trading in digital options tougher, it is also more exciting as the potential returns are greater for a lower risk or investment.

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