A knock-out option belongs to a category of exotic options – options which have more complex features than plain-vanilla options—generally known as barrier options. Barrier options are options that either come into existence or stop to exist when the value of the underlying asset reaches or breaches a pre-defined price level inside an outlined time period.
Knock-in options come into existence when the value of the underlying asset reaches or breaches a selected price level, while knock-out options stop to exist (i.e. they’re knocked out) when the asset price reaches or breaches a price level. The fundamental rationale for using a majority of these options is to lower the associated fee of hedging or speculation.
Key Takeaways
- Knock-out options are a style of barrier option, which expire worthless if the underlying asset’s price exceeds or falls below a specified price.
- There are two kinds of knock-out options: up-and-out barrier options and down-and-out options.
- Knock-out options limit losses; but, as is usually the case, also limit profits on the upside.
- The knock-out feature is triggered even when the designated level is breached only very briefly, which may prove dangerous in volatile markets.
Knock-out Options Characteristics
There are two basic kinds of knock-out options:
- Up-and-out: The worth of the underlying asset has to maneuver up through a specified price point for it to be knocked out.
- Down-and-out: The worth of the underlying asset has to maneuver down through a specified price point for it to be knocked out.
Knock-out options may be constructed using either calls or puts. Knock-out options are over-the-counter (OTC) instruments and don’t trade on options exchanges, and are more commonly utilized in foreign exchange markets than equity markets.
Unlike a plain-vanilla call or put option where the one price defined is the strike price, a knock-out option has to specify two prices – the strike price and the knock-out barrier price.
The next two details about knock-out options have to be kept in mind:
- A knock-out option can have a positive payoff only whether it is in-the-money and the knock-out barrier price has never been reached or breached through the lifetime of the choice. On this case, the knock-out option will behave like an ordinary call or put option.
- The choice is knocked out as soon as the value of the underlying asset reaches or breaches the knock-out barrier price, even when the asset price subsequently trades above or below the barrier. In other words, once the choice is knocked out, it’s out for the count and can’t be reactivated, no matter the following price behavior of the underlying asset.
Knock-out Options Examples
(Note: In these examples, we assume that the choice is knocked out upon a breach of the barrier price).
Example 1 – Up-and-out Equity Option
Consider a stock that’s trading at $100. A trader buys a knock-out call option with a strike price of $105 and a knock-out barrier of $110, expiring in three months, for a premium payment of $2. Assume that the value of a three-month plain-vanilla call option with a strike price of $105 is $3.
What’s the rationale for the trader to purchase the knock-out call, fairly than a plain-vanilla call? While the trader is clearly bullish on the stock, he/she is sort of confident that it has a limited upside beyond $105. The trader is due to this fact willing to sacrifice some upside within the stock in return for slashing the associated fee of the choice by 33% (i.e. $2 fairly than $3).
Over the three-month lifetime of the choice, if the stock ever trades above the barrier price of $110, it can be knocked out and stop to exist. But when the stock doesn’t trade above $110, the trader’s profit or loss depends upon the stock price shortly before (or at) option expiration.
If the stock is trading below $105 just before option expiration, the decision is out-of-the-money and expires worthless. If the stock is trading above $105 and below $110 just before option expiration, the decision is in-the-money and has a gross profit equal to the stock price less $105 (the online profit is that this amount less $2). Thus, if the stock is trading at $109.80 at or near option expiration, the gross profit on the trade is the same as $4.80.
The payoff table for this knock-out call option is as follows –
| Stock Price at Expiration* |
Profit or Loss? |
Net P/L Amount |
|---|---|---|
| < $105 |
Loss |
Premium paid = ($2) |
| $105 < Stock price < $110 |
Profit |
Stock price less $105 less $2 |
| >$110 |
Loss |
Premium paid = ($2) |
*Assuming barrier price has not been breached
Example 2 – Down-and-Out Forex Option
Assume a Canadian exporter wishes to hedge US$10 million of export receivables using knock-out put options. The exporter is anxious a couple of potential strengthening of the Canadian dollar (which might mean fewer Canadian dollars when the U.S. dollar receivable is sold), which is trading within the spot market at US$ 1 = C$ 1.1000. The exporter, due to this fact, buys a USD put option expiring in a single month (with a notional value of US$10 million) that has a strike price of US$ 1 = C$ 1.0900 and a knock-out barrier of US$ 1 = C$ 1.0800. The price of this knock-out put is 50 pips, or C$ 50,000.
The exporter is wagering on this case that even when the Canadian dollar strengthens, it can not accomplish that much past the 1.0900 level. Over the one-month lifetime of the choice, if the US$ ever trades below the barrier price of C$ 1.0800, it can be knocked out and stop to exist. But when the US$ doesn’t trade below US$1.0800, the exporter’s profit or loss depends upon the exchange rate shortly before (or at) option expiration.
Down-and-out option.
Assuming the barrier has not been breached, three potential scenarios arise at or shortly before option expiration:
(a) The U.S. dollar is trading between C$ 1.0900 and C$ 1.0800. On this case, the gross profit on the choice trade is the same as the difference between 1.0900 and the spot rate, with the online profit equal to this amount less 50 pips.
Assume the spot rate just before option expiration is 1.0810. For the reason that put option is in-the-money, the exporter’s profit is the same as the strike price of 1.0900 less the spot price (1.0810), less the premium paid of fifty pips. This is the same as 90 – 50 = 40 pips = $40,000.
Here’s the logic. For the reason that option is in-the-money, the exporter sells US$10 million on the strike price of 1.0900, for proceeds of C$10.90 million. By doing so, the exporter has avoided selling at the present spot rate of 1.0810, which might have resulted in proceeds of C$10.81 million. While the knock-out put option has provided the exporter a gross notional profit of C$90,000, subtracting the associated fee of C$50,000 gives the exporter a net profit of C$40,000.
(b) The U.S. dollar is trading exactly on the strike price of C$ 1.0900. On this case, it makes no difference if the exporter exercises the put option and sells on the strike price of CAD 1.0900, or sells within the spot market at C$ 1.0900. (In point of fact, nonetheless, the exercise of the put option may lead to payment of a specific amount of commission). The loss incurred is the quantity of premium paid: 50 pips, or C$50,000.
(c) The U.S. dollar is trading above the strike price of C$ 1.0900. On this case, the put option will expire unexercised and the exporter will sell the US$10 million within the spot market on the prevailing spot rate. The loss incurred on this case is the quantity of premium paid: 50 pips, or C$50,000.
Knock-out Options Pros and Cons
Knock-out options have the next benefits and disadvantages:
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Lower outlay: The most important advantage of knock-out options is that they require a lower money outlay than the quantity required for a plain-vanilla option. The lower outlay translates right into a smaller loss if the choice trade doesn’t work out, and a much bigger percentage gain if it does work out.
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Customizable: Since these options are OTC instruments, they may be customized as per specific requirements, in contrast with exchange-traded options which can’t be customized.
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Risk of loss in event of huge move: A significant drawback of knock-out options is that the choices trader has to get each the direction and magnitude of the likely move within the underlying asset right. While a big move may lead to the choice being knocked out and the lack of the total amount of the premium paid for a speculator, it might lead to even greater losses for a hedger because of the elimination of the hedge.
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Not available to retail investors: As OTC instruments, knock-out option trades may have to be of a certain minimum size, making them unlikely to be available to retail investors.
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Lack of transparency and liquidity: Knock-out options may suffer from the overall drawback of OTC instruments by way of their lack of transparency and liquidity.
The Bottom Line
Knock-out options are prone to find greater application in currency markets than equity markets. Nevertheless, they provide interesting possibilities for giant traders due to their unique features. Knock-out options might also be of greater value to speculators—due to lower outlay—fairly than hedgers, for the reason that elimination of a hedge within the event of a giant move may expose the hedging entity to catastrophic losses.
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