Digital options typically are placed into the class of financial instruments referred to as "exotic." However, digital options are simple, and can find a place in the average retail trader's trading toolbox. Exotic options are the tools of multi-million dollar OTC traders with big bank and other financial institutions backing them. Webster's dictionary defines the word exotic as "strikingly unusual or strange in effect, appearance or nature." To consider whether this word is fairly applied to digital options, think of the everyday occurrence of opening your mailbox and finding two discount offers from one of your favorite stores. Offer I: $5 off every purchase of $15 or more - this is the conceptual application of a digital option. Offer II: 20% off any single item - this is the concept of a plain vanilla exchange-traded index option. A digital option is an option whose payout is characterized as having only two potential values - a fixed payout of, say $1, when the option is in-the-money (underlying price above strike for a call and below strike for a put) or a $0 payout otherwise. Using the example of our two discount offers, we will explain the pay-out value for a digital option.
Binary call option: As any call option would, a binary call option pays out if the underlying or market price exceeds the strike price at expiration. Binary Put options: Correspondingly, the binary put option pays out the stipulated amount to an option holder only if the market or underlying price is below the strike price. If any segment of an option payout graph is vertical - that is, it doesn't contain a slope - your position has an element of a binary option, either on a standalone basis or embedded as a component of a compound option (an option on an option).
A speculator betting on rising and falling prices can use digital options as cheaper alternatives to regular vanilla options.
A digital option can be simulated for pricing purposes and replicated for hedging purposes as an aggressive bull spread. Because the payout of a tight bull spread is closely similar to that of a digital option, so is its pricing. Using a forex example, digital options let you wager on whether the exchange rate will trade above or below the trigger level (strike price) at expiration. Alternatively, if the trader is expecting a stable or relatively quiet market with low volatility, then the recommended strategy would be to write (sell) options, as doing so will generate profits in an otherwise unprofitable trading environment. Technological breakthroughs have made computing muscle affordable and available via sophisticated trading software and has simplified the pricing of these not-so-vanilla options. A digital option is an option whose payout is characterized as having only two potential values - a fixed payout of, say $1, when the option is in-the-money or a $0 payout otherwise. For that reason, a digital option is also referred to as a Binary option, a binary number in mathematical or computer jargon is one where each digit can only have two possible values, either 0 or 1.
A bull spread involves buying an option at a lower strike and selling a similar option at a higher strike; the difference in the strikes is the spread risk. If a trading system has the capability of pricing a tight bull spread, it shouldn't be challenging to price a digital option. If exchange rates move unfavorably to the position, the holder exercises his option and trims his losses by a predetermined payout amount, whereas if the market moves favorably, the trader continues to deal in current spot prices and doesn't exercise his option.
Remember, the greater the flexibility and higher the payout for an unfavorable market price movement, the larger the upfront premium associated with purchasing that option. Digital options might not necessarily be an excellent tool for following trends and are not truly adequate for maximizing profits either, but they help protect against a loss of profits.
Marketing digital options as strikingly exotic might hinder demand and sometimes even daunt a pro trader from dealing in them. Applying that terminology, an option that, at expiration, can have only one of two payoff possibilities, a 0 or a 1, is classified as a digital or binary option (these terms can be used alternately).
Trading pitfalls and jolts to profitability can be minimized if the digital options trader recognizes, among other things, the structural subtleties associated with specific trigger levels, related liquidity concerns, and stays alert to any warnings signaled by the greek ratios - delta, gamma, vega, etc.
However, while digital options find themselves among truly exotic trading vehicles, such as look-back options, chooser options and Bermuda options, they are the simplest options of all and individual traders can employ them, if only synthetically. But if you expect increased volatility in light of the announcements, your best choice is to trade options and reduce returivrelat' ed spikes and whipsaws. Using a forex example, digital options let you wager on whether the exchange rate will trade above or below the trigger level at expiration.
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