Use Knock-Out Options To Lower The Cost of Hedging

By Elvis Picardo, CFA AAA

A knock-out option belongs to a class of exotic options – options that have more complex features than plain-vanilla options – known as barrier options. Barrier options are options that either come into existence or cease to exist when the price of the underlying asset reaches or breaches a pre-defined price level within a defined period of time. Knock-in options come into existence when the price of the underlying asset reaches or breaches a specific price level, while knock-out options cease to exist (i.e. they are knocked out) when the asset price reaches or breaches a price level. The basic rationale for using these types of options is to lower the cost of hedging or speculation.

Basic features of knock-out options

There are two basic types of knock-out options:

  • Up-and-out – The price of the underlying asset has to move up through a specified price point for it to be knocked out.
  • Down-and-out – The price of the underlying asset has to move down through a specified price point for it to be knocked out.

Knock-out options can be constructed using either calls or puts. Knock-out options are over-the-counter (OTC) instruments and do not trade on option exchanges, and are more commonly used in foreign exchange markets than equity markets.

Unlike a plain-vanilla call or put option where the only 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 following two important points about knock-out options need to be kept in mind:

  • A knock-out option will have a positive payoff only if it is in-the-money and the knock-out barrier price has never been reached or breached during the life of the option. In this case, the knock-out option will behave like a standard call or put option.  
  • The option is knocked out as soon as the price of the underlying asset reaches or breaches the knock-out barrier price, even if the asset price subsequently trades above or below the barrier. In other words, once the option is knocked out, it’s out for the count and cannot be reactivated, regardless of the subsequent price behavior of the underlying asset.

Examples

(Note: In these examples, we assume that the option is knocked out upon a breach of the barrier price).  

Example 1Up-and-out equity option

Consider a stock that is 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 price of a three-month plain-vanilla call option with a strike price of $105 is $3.

What is the rationale for the trader to buy the knock-out call, rather than a plain-vanilla call? While the trader is obviously bullish on the stock, he/she is quite confident that it has limited upside beyond $105. The trader is therefore willing to sacrifice some upside in the stock in return for slashing the cost of the option by 33% (i.e. $2 rather than $3).

Over the three-month life of the option, if the stock ever trades above the barrier price of $110, it will be knocked out and cease to exist. But if the stock does not trade above $110, the trader’s profit or loss depends on the stock price shortly before (or at) option expiration.

If the stock is trading below $105 just before option expiration, the call is out-of-the-money and expires worthless. If the stock is trading above $105 and below $110 just before option expiration, the call is in-the-money and has a gross profit equal to the stock price less $105 (the net profit is 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 equal to $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 2Down-and-out forex option

Assume a Canadian exporter wishes to hedge US$10 million of export receivables using knock-out put options. The exporter is concerned about a potential strengthening of the Canadian dollar (which would mean fewer Canadian dollars when the U.S. dollar receivable is sold), which is trading in the spot market at US$ 1 = C$ 1.1000. The exporter therefore buys a USD put option expiring in one 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 cost of this knock-out put is 50 pips, or C$ 50,000.

The exporter is wagering in this case that even if the Canadian dollar strengthens, it will not do so much past the 1.0900 level. Over the one-month life of the option, if the US$ ever trades below the barrier price of C$ 1.0800, it will be knocked out and cease to exist. But if the US$ does not trade below US$1.0800, the exporter’s profit or loss depends on the exchange rate shortly before (or at) option expiration.

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. In this case, the gross profit on the option trade is equal to the difference between 1.0900 and the spot rate, with the net profit equal to this amount less 50 pips.

Assume the spot rate just before option expiration is 1.0810. Since the put option is in-the-money, the exporter’s profit is equal to the strike price of 1.0900 less the spot price (1.0810), less the premium paid of 50 pips. This is equal to 90 – 50 = 40 pips = $40,000.

Here’s the logic. Since the option is in-the-money, the exporter sells US$10 million at the strike price of 1.0900, for proceeds of C$10.90 million. By doing so, the exporter has avoided selling at the current spot rate of 1.0810, which would 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 cost of C$50,000 gives the exporter a net profit of C$40,000.

(b) The U.S. dollar is trading exactly at the strike price of C$ 1.0900. In this case, it makes no difference if the exporter exercises the put option and sells at the strike price of CAD 1.0900, or sells in the spot market at C$ 1.0900. (In reality, however, the exercise of the put option may result in payment of a certain amount of commission). The loss incurred is the amount of premium paid, 50 pips or C$50,000.

(c) The U.S. dollar is trading above the strike price of C$ 1.0900. In this case, the put option will expire unexercised and the exporter will sell the US$10 million in the spot market at the prevailing spot rate. The loss incurred in this case is the amount of premium paid, 50 pips or C$50,000.

Pros and Cons

Knock-out options have the following advantages:

  • Lower outlay: The biggest advantage of knock-out options is that they require a lower cash outlay than the amount required for a plain-vanilla option. The lower outlay translates into a smaller loss if the option trade does not work out, and a bigger percentage gain if it does work out.
  • Customizable: Since these options are OTC instruments, they can be customized as per specific requirements, in contrast with exchange-traded options which cannot be customized.

Knock-out options also have the following drawbacks:

  • Risk of loss in event of large move: A major drawback of knock-out options is that the options trader has to get both the direction and magnitude of the likely move in the underlying asset right. While a large move may result in the option being knocked out and the loss of the full amount of the premium paid for a speculator, it many result in even bigger losses for a hedger due to the elimination of the hedge.
  • Not available to retail investors: As OTC instruments, knock-out option trades may need to be of a certain minimum size, making them unlikely to be available to retail investors.
  • Lack of transparency and liquidity: Knock-out options may suffer from the general drawback of OTC instruments in terms of their lack of transparency and liquidity.

The Bottom Line

Knock-out options are likely to find greater application in currency markets than equity markets. Nevertheless, they offer interesting possibilities for large traders because of their unique features. Knock-out options may also be of greater value to speculators – because of the lower outlay – rather than hedgers, since the elimination of a hedge in the event of a large move may expose the hedging entity to catastrophic losses.

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