This page should help those traders who are trying to understand the difference between a regular option and a binary option. First of all . lets look at the term "option". What is it?
Well, an options is something that you can buy or sell that enables you buy or sell a contract. This contract gives you the right to buy or sell an asset such as gold or a currency pair such as EUR/USD. It's one step removed from the actual asset, if you like- a derivative.
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Regular Options, also called Vanilla Options or Traditional Options, are similar to Binary Options (or Digital Options, Fixed Return Options) but there are several important difference.
How are they Similar?
Well both Traditional Options and Binary Options are derivatives. That is to say, they price is derived from an assets value. They are basically contracts that give you the right to buy or sell stocks, currencies, or commodities for example – at a set price on or before a certain time.
You are not actually buying the underlying asset (like gold EUR/GBP or whatever). The price of the asset is merely tracked in both types of options to determine whether either the Vanilla Option or the Binary Option (FRO) contract has expired in-the-money or out-of-the-money.
What's the Difference between a Regular Option and a Binary Option?
Well, there are a number of differences.
Let's cover the most important difference first- the payout!
With a binary option, the payout (how much you get back if the trade is in the money) is set at the beginning of the contract. Both your risk and your profit potential are fixed- which is what makes binary options trading so popular compared to trading forex on margin, for example, where your losses can exceed your initial investment as your position may be geared.
With a binary option, the predetermined payout on a winning trade can be anywhere between 50 – 90%. With regular options, the payout can vary and will depend on "how in the money you are"- the amount of movement the price of your asset has made beyond the strike price, in other words. But also importantly, you can lose an amount that will depend on the size of the movement if your trade is out of the money too. Digital options only have 2 outcomes (that's why they are called Binary Options). You know what your profit and loss will be before you make the trade. There is no additional risk.
There is also a difference in the way the expiry time is set up between Standard Options and Binary Options. Vanilla options generally expire on a monthly or quarterly basis and many traders use them to hedge their trades. Binary Options tend to be much more flexible, with s at hourly, daily, weekly and monthly expiry times (and even shorter).
A regular option can be executed at any time right up to the expiry time. You can close your trade at any point, With a binary option, you must hold the investment until the expiry time (there are exceptions to this). Generally speaking, however, traditional options are more flexible than FRO's (binaries) when it comes to selling them.
Risk vs Reward
The overall risk with binary options is lower than with standard options. It's for this reason that they have become such a popular way of playing the stock markets and forex markets. You can never lose more than your original investment, which is not the case with standard options or forex trading (or CFD's for that matter).
However, the flip side, is that if a trade pulls away in the direction that you correctly forecast, yu are only ever going to make a fixed return. You would need to open up another trade (or contract) to benefit from a bull run, for example. Traditional options can be leveraged, much like forex positions. This can increase your potential for rewards, but it also increases the risk.
So for this reason, binary options are seen as a safer bet for those traders who are relatively new to trading stocks, commodities, indices and shares. And they can also be used as a useful hedge for forex traders as insurance for trades going the wrong way.