There is an interesting new product that is starting to take shape in the Forex and CFD world and that is the concept of a Digital contract. It is in essence a combination of a binary option and a CFD.
This has been introduced as a trading option on a number of broker platforms recently. For example, it is currently on offer on the SpotOption 5 platform as well as the proprietary IQ option platform.
Although this may be a new instrument, traders who usually trade Binary Options or CFDs may find that digital contracts could suit their trading strategy more appropriately.
In this post we will go over some of the key aspects of digital options, who you can trade them with and what sort of option based strategies you can implement with these products.
What is a Digital Contract?
A digital contract is a derivative instrument that has an expiry time, strike rate and option type. Similar to options, it can either be a CALL (price going up) or a PUT (price going down).
If at the time of the expiry, if the price is above the strike price and the trader chose to enter a CALL option, then they will get the pay out on that trade. Of course, the opposite can be said for the PUT option.
If, however, the trade went the other way and the price failed to go above the CALL price then the digital contract will expire worthless and the trader will have lost their initial investment.
There may be some traders who are wondering how this might differ from a Binary Option. Although they are indeed quite similar, there are one or two distinct differences that make them unique.
Firstly, with a digital contract, the trader chooses the strike and the payoff is then determined on that. This means that the range of strike prices that are available to the digital contract trader are way more diverse than that of the Binary Option.
Indeed, when trading a digital contract with a strike price that is considerably above the current rate, the pay-out can be as high as 1,900%. This is indeed a lucrative option for those traders in search of “long tail” events.
Secondly, unlike Binary Options, you can exit a trade on a digital contract before it has expired at a profit. This is what makes it slightly more analogous to a CFD. There is no obligation to hold out to the end.
Some traders may also have seen the high pay-out rate on the digital contract and seen some of the parallels of the 100% pay-out that some traders used to get trading one touch options.
Who Offers Digital Contracts?
At the moment, there is only one white label platform that we know offers digital contracts. That is the SpotOption platform with their Spot5 platform. Spot5 is their revolutionary new market offering and is already taking the market by storm.
Another broker that offers digital contracts is by the market leading IQ Option platform. Digital contracts were part of the new offer that they included in their updated platform. Other products included with the update IQ option platform were Crypto CFDs and American options.
An example Digital Contract Trade
We will take a look at an example of a digital contract trade so that you can get a better sense of how the instrument is priced and how the payoff is determined.
Below, we have an example of a digital contract on a SpotOption platform. We have selected to trade the Australian Dollar and Japanese Yen cross with the digital contract.
With the Spot5 platform, the digital contract has 15 minute rolling expiry times. This means that the expiry times are defined at 15 minute intervals throughout the day. Traders can set their expiry times by entering the trade at any point before the expiry.
As you can see, to the left of the trade, one can then select your chosen expiry rates. There are at least 8 different expiry rates with this digital contract. These range from well in the money from a PUT / CALL perspective to expiry rates that are closer to strike.
As you can see, the payoffs range from 0-1,900% above and below. Of course, the latter will be a rate that is considerably out of the money and the former will be a rate that is closer to the strike price.
We have the view that AUDJPY will expire above 87.877 in 5 minutes. With the current rate at 87.811 we could get a payoff of 624% on our initial investment. If, however, we had decided to enter a PUT digital contract, our payoff would have been 8.46%.
If one was to think of it in option terminology, digital contracts give the trader the opportunity to sell options that are well in-the-money already and hence generate a relatively minor pay-out. Of course, this is also similarly risky given the stake invested.
In the case of our CALL trade on the AUDJPY, you can see that there is also the option to close out of the trade early. At the current rate on our trade (87.844) we can close out of this trade at secure a profit of $11.80.
At contract expiry, unfortunately the rate was at 87.869 which was below the strike that we selected for the CALL option. We lost the trade and hence lost our initial investment of $14.
Digital Contract Trading Strategies
Given the unique nature of a digital contract, there are a number of strategies that one can implement with the instrument. These strategies are used with both Binary Options and CFD strategies.
Even though they are a new instrument, some of the team at FXaxe have tried using some of these strategies while trading. Below are some interesting strategies that you may want to consider.
Scalping Digital Contracts
For the seasoned Forex and CFD trader, scalping may be well known to them. In its essence, scalping is a strategy where the trader enters a trade and exits it a short time afterward at a minor profit.
This is also a strategy that is not liked by a number of brokers and is banned by some. Traders usually make use of technical analysis studies when placing scalping trades. This is because they are in the belief that momentum will keep trending.
Scalping was usually quite difficult to do with binary options as the trader had to place the trade near expiry and had to rely on expiry times usually to a minimum of 60 seconds.
Given that digital contracts can be exited before expiry at a profit, the trader can use them as a quasi CFD / Forex instrument with defined payoffs.
Scalping with a digital contract has one main advantage over a CFD though, a limited downside loss. CFDs require very tight stop losses in place in order to avoid large drawdowns from incorrect trades.
We will take a look at a quick scalping example with a digital contract on Gold. We expect that there is some positive momentum as a result of some key moving average indicators.
Hence we wanted to position a long trade in expectation for a positive continuation. As can be seen in the below chart, we entered a CALL digital contract with an expiry strike price of 1,230.605. The current rate was 1,230.310 and the contract was priced at 47.7.
With this trade, the digital contract was slightly out of the money with 100% pay-out if the option expired in the money. However, we will not be waiting till expiry of this contract as we are scalping.
As one can see below, a few minutes into the trade, the market rate (1,230.920) is slightly above the strike price that we chose to enter into. The digital contract is also valued at 58.4.
The scalper wants to realize the profit on the trade in true scalping fashion. Hence, we will close out the trade and take the current profit on the trade at $10.
Of course, the trade could have gone the other way yet we know the maximum that we would lose on the digital contract is the amount that was original investment amount of 50.
Bollinger Bands & Digital Contracts
We have previously covered Bollinger band option strategies but with the advent of digital options, there is greater scope to use a number of these strategies with greater effect.
Given the number of trading levels and expiry levels is quite broad with digital contracts, the trader can identify key support and resistance levels and then place trades around those levels.
As you may know, the upper and lower Bollinger bands are sometimes used as an example of key support and resistance levels assuming certain conditions have been met. Hence, the trader can place digital contract trades outside of these levels.
For example, taking a look at the below chart of the EURUSD again with the (2,20) Bollinger band plotted. We can see that the upper Bollinger band is acting as a resistance level for the pair to break out from.
Knowing this, the trader can enter a digital contract PUT option at a strike rate of 1.14217. This is above the upper Bollinger band and hence the resistance level. The digital contract is also in the money and if it expires in the money the payoff will be 17%.
Indeed, one can see that the market is already reflecting this fact by offering payoffs that are quite asymmetric around for the CALL and PUT. Waiting till the expiry we can see that the digital contract indeed expired in the money below.
The trade expired below the strike at 1.14139 and the pay-out was $16.10. Similar to scalping, the pay-out is not as large as it would be if the trader had entered a CALL but statistically the trends were more in favour of the price remaining below these levels.
Price Action Trading
Of course, digital contracts can be used for trading using fundamental analysis such as price action trading. This could include market events like economic data releases which are by their nature usually limited to three outcomes, in-line with expectations, exceeded or below.
The really large pay-out that a trader can expect from digital contracts that are far out of the money could indeed be realized in situations when the market is extremely volatile. This is typically the nature of currency markets when there is an important piece of economic news.
This makes digital contracts preferable to CFDs and Forex when trading price action events. In order to achieve high returns with CFDs and Forex they would need to take considerable leverage. This is obviously quite risky especially if it goes the other way.
As the markets are extremely volatile, the price can go through any stops that were put in place for a leveraged trade. This could mean a trade that potentially wipes out any equity in the trading account. However, as downside is limited to the initial investment with a digital contract the trader can have more certainty of outcomes.