What is Knockout Option?
A knock-out option is a derivative contract in option, which loses its entire value if the price of the underlying asset reaches up to a certain level and option contract expires worthless. In such a case, the buyer does not get payoff and option writer receives fixed payoff if the price of the underlying reaches up to a certain level. Knock-out price decides the level of options contract that the buyer or seller (writer) can hold.
Stock X trading at $200 per share, an investor decides to buy a call option of strike $210 at with a knockout price is $220 at $2. In plain vanilla option call option of a strike, $210 is at $5. The buyer is bullish on the stock, but have a doubt regarding the price level will cross above $220. If by the expiry of that option, the contract price of the stock reaches the level of $220, then the option contract will expire worthlessly. In case it does not hit $220, then the option continues to be valid until the expiry of the contract.
- Scenario 1: The stock price of X remains below $210. In this case, the Knock-out call option buyer will face a loss of $2, and regular option buyers will face a loss of $5 since the call strike becomes out of money.
- Scenario 2: The stock price of X is above $210 but not above $220. In this case, the knockout option buyer will have more benefit since the price paid to buy a call of $210 is $2 compared to the regular option buyers.
Assume if the stock price of X by the end of the options contract period is $218, then the regular option buyer will get a profit of $3 ($218-$210-$5=$3), and Knockout option buyer will receive a profit of $6 ($218-$210-$2=$6)
- Scenario 3: The stock price of X crosses the level of $220, the knockout option ceases to exist while the regular option trader will continue to receive profit as per price.
Assume if the stock price of X is $250, then a regular call option buyer of $210 at $5 will get a profit of $35 ($250-$210-$5=$35).
- Knockout Option: If the underlying asset price crosses a predetermined price, the option contract becomes worthless.
- Knock-in Options: Option contracts becomes valid and comes into existence only after the price of an underlying asset reached a certain price.
Knockout options traded in over the counter (OTC) market, mostly used in commodity and currency markets by large businesses to manage their positions. Only in case of in the money option contract, there is a positive payoff only if the option strike is in the money at the expiry, and the knockout price is not breached by the underlying asset.
Why would the buyer Prefer to Buy a Knockout Option?
- This is cheap in comparison with plain vanilla options traded on the exchange.
- In international business, such an option is used to achieve small profits instead of speculating major movements within the life of trade.
- Since the knockout option contract is customized contracts, it can be adjusted as per individual needs compare to exchange-traded option contracts where terms are regulated by an exchange.
#1 – Down and Out Options
An option contract that gives right but not obligation to buy or sell the underlying asset at a certain price only if, price of an asset does not fall below the given barrier of price during the option contract period.
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The stock price of Stock XYZ is $100. The buyer decides to buy a call option of strike $90, while the barrier on the downside of the stock is $80. Before the expiry of an option contract, if Stock XYZ touches $80 price, this call option will expire worthlessly.
#2 – Up and Out Options
An option contract gives right but not the obligation to buy or sell the underlying asset at a certain price only if, price of an asset does not go above the certain barrier of price during the option contract period.
Stock XYZ trading at $100. The buyer decides to buy a put option of strike $90 with a barrier on the upside is $120. If within the life of the options contract underlying asset does not cross the price of $120, then the option contract continues to be valid; otherwise, it expires as worthless.
Difference between Knock-out Options and Knock-in Option
|Particulars||Knockout Option||Knock-in option|
|Definition||Options contracts, which get expired as worthless if the price of an underlying asset reaches a certain price.||An option contract, which will come into existence only if the price of an underlying asset reaches a certain price.|
|Good for||Beneficial for speculators.||Beneficial for hedgers and speculators.|
|Expectation||The certain price levels will not be breached by an underlying asset.||Certain Price level needs to breach to activate knock-in options.|
|Risk||In the case of a major movement in the market, a knockout option will be worthless.||In the case of stagnated or low movement in the market, Knock in options will not make any sense.|
- Limited Cash Outflow: Compare to other option contracts, cash flow payout is very less, resulting in the limited loss if the trade is not executed as per expectation.
- Tailor-made Contracts: Knockout options traded in the OTC market; it helps in personalizing option contracts so it can be made as per requirement.
- High volatility risk: Trader need to analyze risk in the up and downside since, in case of major movement, traders will lose an opportunity or might face loss.
- No Hedging opportunity: Traders who prefer to hedge their positions with options to avoid major loss might face a huge loss in case of major movements against the trade, and such an option might be worthless.
- OTC Contracts: For a regular trader, such an option is not available since it is available in the OTC market.
- Lack of liquidity and regulator in a contract: There is a risk of default in case of OTC contracts since both parties depend on each other for trust. It is very little or almost no liquidity in the knockout option since it is tailor-made as per the need of an individual.
Knockout options are highly preferable for commodity and currency markets because of its features. In less volatile market speculators who still want to generate profit, such options are a better choice since the price is comparatively lower than the regular exchange-traded option, while terms and periods can be customized.
This has been a guide to what is Knockout Options? Here we discuss examples, types, and why buyers prefer to buy knockout options along with advantages and disadvantages. You may learn more about financing from the following articles –