Learn 100% online from anywhere in the world. Enroll today!

Digital Option

A form of option that allows traders to manually set a strike price

What is a Digital Option?

A digital option is a form of option that allows traders to manually set a strike price. The digital option provides the traders with a fixed payout in the case when the market price of the underlying asset exceeds the strike price. The feature of setting the strike price manually brings the risk associated with trading and the potential benefits under control.

 

Digital Option

 

Digital options enable investors and traders to benefit from accurate predictions on assets’ future price. They offer traders with two possible outcomes of any trade – traders earn a profit if their predictions are correct, or else, must lose their initial output. The digital option enables the traders to trade in a wide variety of financial instruments.

 

Summary

  • A digital option is a form of option that provides traders with the opportunity of a fixed payout when the market price of the underlying asset exceeds the strike price.
  • Digital options offer traders with two possible outcomes of any trade – traders earn a profit if their predictions are correct, else they must lose their initial output.
  • A digital option will be exercised only when the actual price does not match the strike price.

 

Working of a Digital Option

A digital option combines the characteristics of a classic option, binary option, and on-touch option. The amount of probable profits can be varied by the traders by adjusting the strike price. The trading risk can be minimized if the traders set the strike price close to the current market price. They can also increase their risk by setting the strike price away from the current market price in the hopes of receiving higher profits.

A digital option provides traders with statements with yes or no as the two possible outcomes, and the traders speculate on the probability of occurrence of the event until the option remains open. The digital option trades are short term with an expiry time varying between one and five minutes. The traders are free to exit their trade before the expiration time, and thus, lock in profits and minimize losses.

The traders choose the asset, expiration period, and the amount to be invested. They select strike price and click CALL if they believe that the price of the asset will increase or PUT if the price is believed to decrease. Then the traders either wait for the expiration period or sell the digital option before the expiry.

The minimum and maximum trade size of a digital option are $1 and $20,000, respectively. Moreover, traders need to pay an upfront fee known as the premium, which is limited to $100. The premium is equal to the maximum amount that a trader can lose for a digital option.

A digital option will be exercised only when the actual price does not match the strike price. Hence, a call option will be exercised if the actual price is more than the strike price by at least one pip (point in percentage) and should be below the strike price by a minimum of one pip for a put option to be exercised. In case a trader believes that the trend is not going in the right direction, he/she is free to sell the digital option anytime.

 

Features of a Digital Option

  • A digital option is a currency pair-based short-term trade.
  • The maximum losses for a digital option can be close to 100%, whereas profits can be as high as 900%.
  • The traders can close the trade of a digital option any time before the expiry. If the trader believes that he/she will receive more profits in case of an early exit, the trader can exit before the expiry of the trade.
  • A digital option comes with a life of five minutes. Hence, traders are allowed to enter a trade up until the last 30 seconds of expiry.
  • Trading in digital options closes only from 7:30 p.m. to 10:30 p.m. (UTC).
  • A digital option enables a trader to open a lot of trades until the last 30 seconds of the trade’s life. However, only experienced traders are capable of making money by entering multiple trades. Traders can lose a huge amount of money if they lose control.
  • The amount of potential profits varies with the strike price. The potential profits increase if there is a wide gap between the strike price and the actual price, and vice-versa. However, traders need to remember that if the strike price is pushed away from the actual price, risk will also increase.

 

Example of a Digital Option

Suppose it is 11:00 a.m. EDT, and gold is presently trading at $1,480. An investor believes that the gold price will close at a price less than $1,480 on the same trading day.

So, the investor decides to buy a sell option at the strike price of $1,400 with the end of the trading day as expiry. Hence, the investor will receive a return if the prediction is correct and the gold price decreases below $1,480, else will make a loss.

 

Additional Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Day Trader
  • Digital Currency
  • Exotic Options
  • Max Pain (Options)

Corporate Finance Training

Advance your career in investment banking, private equity, FP&A, treasury, corporate development and other areas of corporate finance.

Enroll in CFI’s Finance Courses

to take your career to the next level! Learn step-by-step from professional Wall Street instructors today.