Binary Options VS. Vanilla Options
History of Options Trading
Speculation trading stayed within the elite preserve of professional and institutional investors and was accomplished by over-the-counter dealings by the use of minimum regulatory control. The first noteworthy event to transform the image of options trading occurred in 1971 when the Chicago Board of Trade designed the first supervised options trading platform by forming the Chicago Board Options Exchange (CBOE). The CBOE was the groundbreaking body which still functions these days as one of the biggest options trading environment in the world.
Binary options, also known as digital options, are similar to ordinary options in the sense that the payoff is based on the price of the underlying asset when the contract expires, however, with a binary option, a trader only needs to take a view on the anticipated direction of the underlying asset price and doesn’t need to take magnitude into consideration.
Binary options are also called ‘all-or-none’ options because of the nature of the payout: it is either the trade is in the money and the trader wins all of it, or the trade is out of the money and he wins none.
A Vanilla Option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, within a given time frame. A vanilla option is a normal Call or Put option that has standardized terms and no special or unusual features.
In vanilla options, an investor pays per contract (i.e. point). Subsequently the investor will profit or lose an amount depending on the number of points difference between the expiry level and the strike price.
Some of the features and definitions of exotic options are given below:
Call Option — Option to purchase the underlying asset.
Put Option — Option to sell the underlying asset.
Exotic Option — Any option with a complex structure or payoff calculation.
Options Contract — The agreement between the writer and the buyer.
Expiration Date — The last day an options contract can be exercised.
Strike Price — The pre-determined price the underlying asset can be bought/sold for.
Time Value — The additional amount that traders are willing to pay for an option.
Intrinsic Value — The current value of the option’s underlying asset.
American Option — Option that can be exercised any time before the expiration date.
European Option — Option that can be exercised only on the expiration date.
Find More definitions of Binary Options Trading on our Glossary Here.
Trading Vanilla Options
There are a large number of brokers who provide vanilla options trading.
Vanilla options can be traded in 4 ways discussed below:
1.Long call
If a trader believes that a stock’s price will increase might buy the right to purchase the stock (call option) rather than just purchase the stock itself. He would have no obligation to buy the stock, only the right to do so till the expiration date. So if the stock price at expiration is above the exercise price by more than the paid price, the options trader will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless and will only lose the amount of the premium or the paid amount.
2. Long put:
In a long put position, the investor expects the stock to fall. As the underlying security declines, the Put will increase in value. Purchasing a Put gives the investor the right to sell shares of stock at a set price called the strike price. A Put option investor is looking to take advantage of a stock’s decline without worrying about margin requirements involved with shorting the stock which is a big plus for traders who are interested in short playing.
3.Short call:
It is a bearish options strategy that involves short selling or writing call options. When the stock falls below the strike price of the call options by expiration, the call options expire worthless and the entire premium from sale is earned. When you short sell, you are selling a security without actually owning it, in a hope that you can buy it later when the price falls and repay your loan and exit altogether.
4.Short put:
If the options trader is bullish and believes the market will rise , he can sell or short puts. Sellers do have obligations though. A put seller has the obligation to buy 100 shares (per option) of the underlying stock at the put strike price. In other words, the option seller must be ready to have the stock “put” to him or her. The put seller’s risk is the drop in the stock price, which is limited to the stock falling to zero. The profit equals the credit received from the sale of the put. Put sellers often prefer options with less time left until expiration because they want a put to expire worthless. So in this way, the seller keeps the entire premium. A short put is covered or offsetted by purchasing a put with the same strike price and expiration to close out the position.
Why Vanilla options suck:
1. Too much complicated for a novice trader.
2. With the wide range of prices available, some will suffer from very low liquidity making trading difficult.
3. Vanilla options trading most of the times (though not necessarily) requires higher capital than trading other assets.
4.Hedging in options provides you the insurance on your shares or option positions and protects the value of you assets.
Why Vanilla Options dont suck:
1. Risk is limited to the option premium (not when writing options for a security that is not already owned).
2. Options allow you to employ considerable leverage. This is an advantage to dsciplined traders who know how to use leverage.
3. Provides a wide variety of strategies while trading options by taking use of market volatility and time decay.
4. Very handsome leverages.
Difference between Binary and Vanilla Options:
Some of the major differences are discussed below:
1.In-The-Money:
Price movement isn’t relevant, just the direction (above or below)
while Vanilla Options Require a relation of the strike price of an option and the underlying price in order to execute the option.
2.Payout:
In Binary Options payout is fixed ,in Vanilla options payout is Dynamic, based on the underlying asset price.
3.Expiration:
In Binary Options there are variety of expiration terms: end of day, hourly and even shorter expiration like 15 min binaries are available while in Vanilla Options expiration is once a month.
4.Execution:
Binary Options can’t be exercised before expiry ,Vanilla Options usually can be exercised any time prior to expiry.
5.Right to buy:
Don’t have the right to exercise to stocks while the vanilla options owner has the right to exercise his options and turn them into stocks in case option expires ‘In-the-money’.
The Bottom Line
Generally speaking there are two schools of thought when it comes to binary options. The first group considers binaries to be an improvement on the standard, rather involved vanilla options; the second group considers binary options to be a form of gambling rather than a form of investment or trading.
It must be conceded that binary options are high risk, high return financial instruments and thus may risk and returns from binary options trading may resemble those associated with betting. However, trading binary options is no different than many other forms of speculating on the financial markets such as vanilla options trading, futures trading and more and should thus not be considered anything other than financial investing.
Discuss on other Newbies issues with Ammad and our Binary Options Traders Community on the Forum!