Understanding Digital Options: Risks & Realities

A digital option trading account is one that is touted as a way to simplify your ability to trade in upswings or downturns in the market with little risk. Lets set aside or debunk a few myths about digital option platforms and websites that promote them before discussing how they work. First, all options trading involves risk, including the risk that you may potentially lose all of the money that you invested, or be exposed to an unlimited risk potential. Period.

A Caution Regarding Digital Options

A digital option is often promoted as an exotic option trading platform that provides a near guarantee return of upwards of 75 to 80 percent over the invested amount. This should trigger a red flag, as was the case with the mortgage backed security derivatives of several years back. These include the credit default swaps that lead to the failure in the mortgage lending industry and near collapse of the U.S. economy, attributable to these “toxic assets.” Before investing in any such exotic investment type, such as digital options, ask for specific illustrations that show not only promissory returns, but any potential risks that are associated with these types of investments.

Binary Options

With this caution out of the way, digital options are made easy, as advertised by using what are known as binary options. A binary option is a financial instrument that is based on a fixed profit that is a percentage of the amount you invest. This differs from standardized options in that the expiration for a binary option is daily or hourly, whereby most standardized option contracts expire in 9 months, except in the case of leaps that can expire up to 2 years. The exposure to risk with a binary or digital option is fixed, whereby your risk associated with a standardized option can be unlimited.

Risk Disclosures Related to Digital Options

Digital option contracts, which also are referred to as fixed rate options, are governed in the same manner as standardized options. The Chicago Board of Option Exchange (CBOE) instituted a rule change in 2007 in order to modify its risk disclosure document, “Characteristics and Risks of Standardized Options.” This was to accommodate a section dealing with digital options. The rule change allowed the CBOE to require the same risk assessment and regulatory oversight over digital options that they do for standardized option contracts.

Easy Digital Option Trading

Because digital options expire almost instantly once they move into a profitable position, which is up for a call or down for a put, they present a lower risk potential than do standardized options. But this is not to be taken to mean that digital options are not without risk. All investing involves risk. This is why the use of terms such as easy digital option trading should be taken out of your vocabulary and replaced by understanding fully the risks associated with these types of investment contracts.