Digital options definition
What is a digital option?
A digital option – also known as a digital 100 – enables a trader to make a prediction about whether a statement about a given market is true or false. If a trader is correct in their prediction, they will make a profit. If they are wrong, they will incur a loss.
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How do digital options work?
Digital options work by offering two possible outcomes – agree or disagree – for a market statement, such as ‘the FTSE 100 will close above 7380’. In this scenario, the trader will buy the digital option if they agree with the statement and they will sell if they disagree.
The price quoted in a statement is known as the strike price. A trader will require the underlying market to close above or below this level in order to realise a profit, depending on whether they have agreed or disagreed with the statement.
Digital 100s are priced between zero and 100, with zero meaning that a broker feels an event is extremely unlikely and 100 meaning that they think it is highly likely. With IG, digital 100s are priced according to the option’s time to expiry, the current price of the underlying market and any expectations of future volatility.
When dealing digital options, a trader’s profit or loss is determined by the difference between the price at which they bought the digital option, to the closing price of either zero or 100. This would be multiplied by the amount the trader has staked per point of movement.
Digital options example
As an example, let’s assume that a trader wants to take a position on a digital 100 for the statement, ‘the FTSE 100 will close above 7380’. Based on the fact that the FTSE 100 is currently trading at 7386.63 and there is only a one hour left until the market closes, the trader believes that this is likely to happen and so buys the digital 100.
The price quoted for buying is 71.5, and the trader decides to stake £10 per point of movement. In this example, the maximum profit would be £285 – this is the difference between 71.5 and 100, multiplied by ten for each point of movement. The maximum loss would be £715, which is the difference between 71.5 and zero multiplied by ten.
Here, the maximum loss is larger than the maximum profit. This is because the underlying market is currently trading above the strike price of 7380, and so the broker has made an assessment that the FTSE is more likely to close above this level than below it.
How to take a position on digital options
Due to regulatory restrictions, digital options are only available to professional traders. Retail clients can find out whether they qualify for a professional account on our professional account page.
Professional traders can take a position on digital options with IG’s digital 100 offering and speculate on the price of a range of markets. These include popular indices such as the FTSE 100, Wall Street and NASDAQ, as well as commodities such as gold and silver, and a selection of popular forex pairs.
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