A digital option is a type of option that offers the opportunity of a fixed payout if the underlying market price exceeds a pre-determined limit, called the strike price.
Digital options allow traders to profit from correct predictions on the future price of an asset. They are based on a statement with only two possible outcomes – yes or no – and enable you to speculate on the likelihood of the event occurring before the option expires.
Digital options work by offering two possible outcomes from any given trade: if your prediction is correct, you generate a profit. If you’re incorrect, you lose your initial output.
Before opening a position, you’d decide whether you think your chosen market’s price is headed up or down. If you believe it will be go up, you’d buy a digital option known as a call. If you think it will go down, you would buy a digital option known as a put.
Calls return a profit if the underlying market’s price is above the strike price when the option expires. Puts are the opposite – they return a profit if the underlying market’s price is below the strike when the option expires.
For example, it is 1pm (London time) and gold is trading at $1280.
You believe that by 3pm of the same day, gold will have increased in value, so you decide to buy a call option with a strike price of $1300. Though the market may move around in the next two hours, it only matters what the price of gold is at 3pm.
If your prediction is correct, and gold is trading above $1300 by 3pm, you will see a return on your money. However, if the price of gold decreases by 3pm, you would make a loss instead.
To find out more about options read our What are options and how do they work page.
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