Vanilla Options Vs. Binary Options – A Closer Look
The growth and widespread adoption of online financial trading has given rise to many innovative products designed to help traders maximize their efficiency and improve their profitability. With many new and inexperienced traders entering the market, demand for simplicity has never been greater. That’s where options come into play. There are two types of options that are synonymous with the online retail financial market – vanilla options and binary options. In this article we explain what they are and how they differ from one another.
When it comes to simplicity, binary options have it made. These options offer a simple way to trade price fluctuations on the global market. However, just because they are called binary options doesn’t mean they act or behave like traditional options, which are contracts that give the holder the right, but not the obligation, to buy or sell a financial asset at a specific price on or before a pre-specified date1.
Binary options are considered to be exotic instruments, despite being very easy to use and understand. In the case of a binary option, the payoff is structured to be either a fixed amount of money if the option expires “in the money” or nothing at all if the option expires “out of the money.”2
There’s a lot of terminology here we need to dissect, so bear with us.
In the case of a call option (i.e. an option to buy an asset), “in the money” simply refers to when the option price (called a “strike” price) is below the market price of an asset3.
In the case of a put option (i.e. an option to sell an asset), “in the money” refers to a situation where the strike price is above the market price of an asset4.
Clearly, the above definition shows that binary options are an ‘all-or-nothing” approach to trading in the financial markets. Some traders may find this appealing because all that is required is deciding whether an index, commodity or currency pair will rise or fall. That decision will determine whether the trader chooses a call or a put.
However, traders need to keep in mind that different options have different fees, risks and payouts, not to mention varying degrees of liquidity5. For this reason, many binary options programs have a very poor reputation, with many service providers promoting them as a get-rich-quick scheme6. It is also much more difficult to find established brokers in this arena, given that binary options are a relatively new phenomenon in the online retail trading world.
For these and other reasons, there has been a bit of a grey area concerning the regulatory aspect of binary options. In 2012 the Cyprus Securities and Exchange Commission (CySEC) became the first EU Markets in Financial Instruments Directive (MiFID) member to recognize binary options as financial instruments7. In places like Malta, for example, binary options were previously classified under the country’s Lottery and Gaming Authority before being moved under the MiFID protocol. Therefore, the contention between “gambling” and “trading” has always been present in the binary options market8.
A vanilla option is a financial contract that gives the holder the right to buy or sell an asset at a particular price on or before an agreed upon date. In this sense, a vanilla option is a standard call or put option with pre-specified terms and no special features. As such, it is generally traded on major exchanges such as the Chicago Board Options Exchange (CBOE)9.
Vanilla options have been widely regarded for their simplicity, but are sometimes wrongly associated with binary options. To be clear, both instruments are not the same. Unlike in binary options, vanilla options require that the trader pays per contract (also known as a point). In this case, profit and loss are determined by the price of an asset when the option expires, less the strike price of the option10.
Also unlike binary options, where contracts usually expire within 24 hours, vanilla options provide much longer expiry dates up to six months. This allows traders greater flexibility to profit from changing market dynamics. After all, vanilla options are very much susceptible to the same market movements that govern other financial assets.
Like binary options, vanilla options allow traders to access currency pairs, commodities and other financial assets. Vanilla options also offer more flexibility than spot forex or CFD trading.
Putting It All Together
Clearly, there is growing demand for both binary options and vanilla options. As online retail financial trading continues to grow, so too will demand for basic, easy-to-understand trading products. This will likely ensure that the market for options continues to grow over time.
In the meantime, the binary options market has some work to do in cleaning up its image. The UK Treasury recently announced plans to change binary options’ legal status to investing from gambling, which should help provide greater regulatory certainty around this instrument. It will also help to bolster its legitimacy worldwide.
According to a spokesperson for the UK Gambling Commission, binary options providers “will not, for the time being, require a gambling operating licence to offer binary options, and no application to the Gambling Commission to do so will be necessary until further notice11.”
1 Investopedia. Options Basics: What Are Options?
2 Investopedia. Binary Options.
3 Investopedia. Strike Price.
4 Investopedia. In The Money.
5 Cory Mitchell. What You Need To Know About Binary Options Outside The U.S. Investopedia.
6 Andriy Morau (February 11, 2016). “Binary Options vs. Vanilla Options in Forex Trading. EarnForex.
7 Michael Greenberg (May 3, 2012). “Binary Options to be regulated by CySec.” Finance Magnates.
8 Andrew Saks McLeod (March 11, 2013). “Gaming or Trading? That is the Question – MFSA To Regulate Binary Options as a Financial Product.” Finance Magnates.
9 Investopedia. Vanilla Option.
10 4-Traders.com (July 3, 2013). “Vanilla Options versus Binary Options.” 4-Traders.com.
11 Avi Mizrahi (April 13, 2015). “UK to Change Binary Options’ Legal Status from Gambling to Investing.” Finance Magnates.
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