What Is a Knock-Out Option?

A knock-out option is an option with a built-in mechanism to run out worthless if a specified price level within the underlying asset is reached. A knock-out option sets a cap on the extent an option can reach within the holder’s favor.

As knock-out options limit the profit potential for the choice buyer, they will be purchased for a smaller premium than an equivalent option with no knock-out stipulation.

A knock-out will be compared with a knock-in option.

Understanding a Knock-Out Option

A knock-out option is a style of barrier option. Barrier options are typically classified as either knock-out or knock-in. A knock-out option ceases to exist if the underlying asset reaches a predetermined barrier during its life. A knock-in option is effectively the other of the knock-out. Here, the choice is activated provided that the underlying asset reaches a predetermined barrier price.

Knock-out options are considered to be exotic options, they usually are primarily utilized in commodity and currency markets by large institutions. Additionally they could also be traded within the over-the-counter (OTC) market.

Forms of Knock-Out Options

Knock-out options are available in two basic types:

Down-and-Out Option

A down-and-out option is one variety. It gives the holder the correct, but not the duty, to buy or sell an underlying asset at a predetermined strike price—if the underlying asset’s price doesn’t go below a specified barrier in the course of the option’s life. Should the underlying asset’s price fall below the barrier at any point in the choice’s life, the choice expires worthless.

For instance, assume an investor purchases a down-and-out call option on a stock that’s trading at $60, with a strike price of $55 and a barrier of $50. If the stock trades below $50, at any time, before the decision option expires then the down-and-out call option promptly ceases to exist. 

Up-and-Out Option

Contrary to a down-and-out barrier option, an up-and-out barrier option gives the holder the correct to purchase or sell an underlying asset at a specified strike price if the asset has not exceeded a specified barrier in the course of the option’s life. An up-and-out option is simply knocked out if the worth of the underlying asset moves above the barrier.

Assume an investor purchases an up-and-out put option on a stock trading at $40, with a strike price of $30 and a barrier of $45. Over the lifetime of the choice, the stock hits a high of $46 but then drops to $20 per share. Too bad: the choice still would robotically expire since the barrier of $45 had been breached. Now, if the stock hadn’t gone above $45 and eventually sold off to $20, then the choice would remain in place and have value to the holder.

Benefits and Disadvantages of Knock-Out Options

A knock-out option could also be used for several different reasons. As mentioned, the premiums on these options are typically cheaper than a non-knock-out counterpart. A trader may additionally feel that the percentages of the underlying asset hitting the barrier price is distant and conclude that the cheaper option is well worth the risk of unlikely being knocked out of the trade. 

Finally, most of these options may additionally be useful to institutions which might be only occupied with hedging up or right down to very specific prices or have very narrow tolerances for risk.

Knock-out options limit losses. Nonetheless, as is usually the case, buffers on the downside also limit profits on the upside. Furthermore, the knock-out feature is triggered even when the designated level is breached only briefly. That may prove dangerous in volatile markets.

Knock-Out Option Example

As an instance an investor is occupied with Levi Strauss & Co., which went public on March 21, 2019, at $17 a share. By May 2, it closed at $22.92 per share. Say our investor is bullish on the historic jeans maker, but still cautious.

The investor may write a call option at $23 per share with a strike price of $33 and a knock-out level of $43. This feature only allows the choice holder (buyer) to profit because the underlying stock moves as much as $43, at which point the choice expires worthless, thus limiting the loss potential for the choice author (seller).