Both Traditional Options and Binary Options are forms of derivatives – their price derived from an assets value. They are essentially both contracts that give the trader the right, but not the obligation, to buy or sell an underlying asset – that can be stocks, currencies, indices, bonds and commodities – at a specific price on or before a certain date.
The asset is used both in Traditional Options and Binary Options trading exists solely as a proxy, as a benchmark for the option itself to determine whether the contract has expired in-the-money or out-of-the-money.
As with most investments the most important aspect to compare between binary options or digital options and traditional options is the payout.
In digital options trading the payout is predetermined at the onset of the contract and can be anywhere between 50 – 90% if the contract expires ‘in-the-money’. In the case of a vanilla option, the payout is variable and the payout is dependent on the size of the assets movement once passed the strike price.
In traditional options, an investor pays per contract (i.e. pips). This means that the investor will profit or lose an amount depending on the number of pips difference between the expiry level and the strike price. This is unlike in binary options where the two outcomes, giving its Bi-nary nature, are fixed from the start.
There is a notable difference in the expiry time between Traditional Options and Digital Options, although less so since Binary Options trading online exploded in 2008. Traditional options generally offer monthly or quarterly expiry times, whereas Binary Options have expiry times at hourly, daily, weekly and monthly points, allowing you to make a trade with just 5 – 15 minutes before the expiry time.
The short term multiple expiry times enable investors to make an instant profit on their digital options providing much more flexibility in their option investments.
The sale of a vanilla option can be executed at any point up to the expiry time. This is unlike the execution of a binary option which can only be exercised at the time of expiry.
An investor in a binary option must hold onto his option until the expiry date. He must therefore take more care when purchasing his options as he cannot sell them once they are purchased, unlike in traditional options where the investor can sell an option at any point before the expiry time, creating more flexibility.
Risk vs Reward
This is where the difference between Traditional Options and Binary Options really gets highlighted. In Binary options, an investor can never lose more than they invested and can even get a refund of up to 15% of their investment amount, even if a prediction finishes out of the money. The reward for such limited risk if the prediction finishes in the money, is less than that a traditional option can potentially offer, which can be from 0 – infinity. However, traditional options can be leveraged which although magnifies the rewards, greatly increases the risk.
It is the risk v reward factor that sees many new traders, with limited or no experience of trading the financial markets. Binary Options offer just simple yes/no investment decisions that can be made multiple times within a day and do not require the constant monitoring of markets over a number of days and weeks to decide whether or not they want to exercise their option to either buy or sell the asset. The rewards can be potentially much higher in traditional options but they can take considerably longer with the increased risk of the profit or loss being dependent on the swing in the movement, which coupled with leveraged trades, can mean losing much more than you invested.