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Knock-Out Option

Updated on January 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Knockout Option?

Knock-out price decides the level of options contract that the buyer or seller (writer) can hold. A knock-out option is a derivative contract in an option, which loses its entire value if the underlying asset’s price reaches a certain level and the option contract expires worthless. In such a case, the buyer does not get a payoff, and the option writer receives a fixed payoff if the underlying price reaches a certain level.

Key Takeaways

  • A knockout option diminishes in value when the underlying asset’s price reaches a specific level, and the option contract becomes worthless. The writer receives a fixed payoff if the underlying price achieves this level, shifting the buyer’s and writer’s risk dynamics.
  • The knockout option landscape includes down-and-out and up-and-out options, each incorporating barriers that trigger value loss when asset prices surpass predetermined thresholds.
  • Knockout options hold appeal in commodity and currency markets due to their cost-effectiveness. They cater to traders seeking profit in less volatile markets, presenting a more economical alternative to standard exchange-traded options. 
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Example

Stock X trading at $200 per share, an investor decides to buy a call option of strike $210 with a knockout price of $220 at $2. In the plain vanilla call option of a strike, $210 is at $5. The buyer is bullish on the stock but doubts that 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. If it does not hit $220, then the option continues to be valid until the expiry of the contract.

Knock-out-Option

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Process

Barrier Options:

  1. Knockout Option: If the underlying asset price crosses a predetermined price, the option contract becomes worthless.
  2. Knock-in Options: Option contracts become valid and come into existence only after the price of an underlying asset reaches a certain price.

Knockout options are traded in the over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more (OTC) market, mostly used by large businesses to manage their positions in commodity and currency markets. Only in the case of the money option contract is there a positive payoff if the option strike is in the money at the expiry and the underlying asset does not breach the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more.

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, it can be adjusted per individual needs compared to exchange-traded option contracts, where an exchange regulates terms.

Types

#1 – Down and Out Options

An option contract gives the right but not obligation to buy or sell the underlying asset at a certain price only if the price of an asset does not fall below the given price barrier during the option contract period.

Example

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 the $80 price, this call option will expire worthlessly.

#2 – Up and Out Options

An option contract gives the right but not the obligation to buy or sell the underlying asset at a certain price only if the price of an asset does not go above the certain barrier of price during the option contract period.

Example

Stock XYZ is trading at $100. The buyer decides to buy a put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more of strike $90 with a barrier on the upside is $120. If within the life of the options contract the underlying asset does not cross the price of $120, the option contract continues to be valid; otherwise, it expires as worthless.

Difference between Knock-out Options and Knock-in Option

ParticularsKnockout OptionKnock-in option
DefinitionOptions contracts expire as worthless if the price of an underlying asset reaches a certain price.An option contract will exist only if an underlying asset’s price reaches a certain price.
Good forBeneficial for speculators.Beneficial for hedgers and speculators.
ExpectationAn underlying asset will not breach certain price levels.Certain Price levels need to be breached to activate knock-in options.
RiskIn the case of a major movement in the market, a knockout option will be worthless.If there is stagnating or downward movement in the market, Knocking on options will not make any sense.

Advantages

Disadvantages

Conclusion

Knockout options are highly preferable for commodity and currency marketsCurrency MarketsFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange.read more because of their features. In less volatile market speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more who still want to generate profit, such options are a better choice since the price is comparatively lower than the regular exchange-traded option. At the same time, terms and periods can be customized.

Frequently Asked Questions (FAQs)

1. What is the importance of the knockout option?

Knockout options play a crucial role in risk management by limiting potential losses for traders and investors. These options have a predetermined barrier level, and if the underlying asset’s price reaches or breaches this level, the option “knocks out,” rendering it worthless. This feature allows traders to control their risk exposure, especially in volatile markets, as they can define a point beyond which their option won’t incur further losses.

2. What are the risks of knockout option?

While knockout options offer risk mitigation, they also come with limitations. The primary risk lies in the possibility of the underlying asset’s price hitting the barrier level, leading to the option’s immediate expiration. This risk can result in missed opportunities if the asset’s price subsequently moves favorably. 

3. What is the knockout vs. reverse knockout option?

A knockout option features a predetermined barrier that, if reached, invalidates the option. Conversely, a reverse knockout option, also known as a knock-in option, becomes active only when the underlying asset’s price reaches a specified barrier level. In a knockout option, breaching the barrier reduces risk, while in a reverse knockout option, crossing the barrier increases risk. 

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