What is a 'Knock-In Option'
A knock-in option is a latent option contract that begins to function as a normal option ("knocks in") only once a certain price level is reached before expiration. Knock-in options are a type of barrier option that may be either down-and-in option or an up-and-in option. A barrier option is a type of contract in which the payoff depends on the underlying security's price and whether it hits a certain price within a specified period.
BREAKING DOWN 'Knock-In Option'There are two main types of barrier option: knock-in and knock-out options. Technically, a knock-in option is a type of contract that is not an option until a certain price is met, so if the price is never reached it is as if the contract never existed. However, if the underlying asset reaches a specified barrier, the knock-in option comes into existence. The difference between a knock-in and knock-out option is that a knock-in option comes into existence only when the underlying security reaches a barrier, while a knock-out option ceases to exist when the underlying security reaches a barrier.
For example, assume an investor purchases a down-and-in put option contract with a barrier price of $90 and a strike price of $100, when the underlying security was trading at $110, with three months until expiration. If the price of the underlying security reaches $90, the option comes into existence and becomes a vanilla option with a strike price of $100. Thereafter, the holder of the option has the right to sell the underlying asset at the strike price of $100. The put option remains active until the expiration date, even if the underlying security rebounds from $90. However, if the underlying asset does not fall below the barrier price at any point during the life of the contract, the down-and-in option expires worthless.
Contrary to a down-and-in option, an up-and-in option comes into existence only if the barrier is reached, which is higher than the underlying asset's price. For example, assume a trader purchases a one-month up-and-in call option on an underlying asset when it was trading at $40 per share. The up-and-in call option contract has a strike price of $50 and a barrier of $55. If the underlying asset did not reach $55 at any point during the life of the option contract, it would expire worthless. However, if the underlying asset rose to $55 or greater, the call option would come into existence.