Options are a form of trading that allow an investor to buy a contract. This contract gives the investor the right to either buy or sell a type of asset such as a forex option or commodity.
A traditional option, which is often referred to as a vanilla option have similarities and differences when being compared to binary options. Binary options are also called fixed return options, digital options, or all or nothing options.
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When comparing vanilla options with binary options it is important to understand that both are different forms of derivatives. This means that the price comes from the value of an asset.
Essentially, both binary and vanilla options are both contracts that give the investor the right, but not an obligation, to sell or buy an underlying asset. This asset may be currencies, stocks, commodities, bonds, or indices and can be purchased for a specified price on or before a specified date.
The asset for both binary options and vanilla options exists as a proxy only or a benchmark for the option itself in order to determine whether a contract expires in or out of the money.
There are several differences between binary options and vanilla options to consider including:
The payout is one of the most important aspects to consider when comparing binary and vanilla options.
In binary options trading the payout will be predetermined and can be between 50 to 90 percent if the contract expires when it is in the money. With vanilla options the payout is variable and depends on the size of the movement of the asset price once it passes the strike price.
When investing in traditional options the investor pays per contract. This means that the trader loses or profits an amount that depends on the difference between the strike price and the expiry level. This is different from binary options where there are only two outcomes as the amount is fixed from the start.
With binary options the movement in price is not relevant. Investors only need to consider whether the price of the asset will go up or down in the allotted amount of time. Vanilla options require a relation to the underlying price and the strike place in order for the option to be executed.
Essentially, in order to finish in the money with a binary option a trader must simply determine if the price is going to go up or if it is going to go down in a certain amount of time. With vanilla options the trader must also think about how much the option will rise or fall during the allotted time.
The expiry time for binary options and vanilla options is notable. A traditional option will typically offer a monthly or quarterly expiry time. Binary options have expiry times that range from as little as 60 seconds, up to an hour, day, week, or month. This allows trades to be made quickly.
Short term expiry times allow investors to make profits almost instantly and provide a lot more flexibility for investments when compared to vanilla options.
Selling a traditional option can be completed at any time up to the expiry time. Binary options can only be executed at the time of the expiry. When investing in binary options a trader must be careful when making a purchase as they can not be sold once they are executed. In vanilla trading an investor may sell the option at any point, which makes vanilla trading more flexible in this regard.
The area of risk and reward is where the main differences between binary options trading and vanilla trading lie. With binary or all or nothing options a trader cannot lose more than what he/she has invested. In some cases binary options traders are even provided with a refund of up to 20% for the amount that is invested, even if it finishes out of the money.
The reward for this limited amount of risk is less than what can potentially be made through a traditional option as the traditional options offer a reward from 0 to infinity. Additionally, it is possible to leverage traditional options, which can magnify the reward, but also increases the risk greatly.
The risk vs. the reward factor is what many new traders who have a limited amount of experience in trading tend to look at. Binary options offer a simple yes or no investment decision which can be made a number of times throughout the day. There is no need to constantly monitor the markets over several days or even weeks in order to determine whether or not they want to buy or sell their options.
The rewards for traditional options can be much higher, but these trades take longer and have an increased risk of profit being lost based on the swing of the movement. When coupled with leveraged trades, it is possible to lose more than you invested.
When it comes to binary options vs vanilla options there are generally two schools of thought. One group considers binary options trading to be an improvement on the rather involved traditional options trading. The other group considers binary options trading to be more of form of gambling than investment.
It must be noted that binary options trading is a high risk, high return financial instrument and can resemble the risks and rewards associated with betting. However, binary options trading is no different than other forms of speculation on the financial markets such as futures trading, traditional trading, and even investing in the stock market.
Overall, binary options trading offers investors a simpler form of the more traditional vanilla options trading as there are only two outcomes available from this type of trading.