What is a Down-and-Out Option
A down-and-out option is a type of knock-out barrier option that ceases to exist when the price of the underlying security falls to a specific price level, called the barrier price. If the price of the underlying does not drop to the barrier level, the option acts like any other option, giving the holder the right but not the obligation to exercise their call or put option at the strike price on or before the expiration date specified in the contract.
BREAKING DOWN Down-and-Out Option
Considered an exotic option, a down-and-out option is one of two types of knock-out barrier options, the other being an up-and-out option. Both kinds come in the put and call varieties. A barrier option is a type of option where the payoff, and the very existence of the option, depends on whether or not the underlying asset reaches a predetermined price. A barrier option can be a knock-out. A knock-out means it expires worthless if the underlying reaches a certain price, limiting profits for the holder and limiting losses for the writer. The barrier option can also be a knock-in. As a knock-in, it has no value until the underlying reaches a certain price.
The critical concept is if the underlying asset reaches the barrier at any time during the option's life, the option is knocked out, or terminated, and will not come back into existence. It does not matter if the underlying moves back to pre-knock-out levels.
For example, a down-and-out option has a strike price of 100 and a knock-out price of 80. At the option's inception the price of the stock was 95, but before the option was exercisable, the price of the stock reached 80. This valuation means the option automatically expires worthless even if the underlying hits 100 before the expiration date.
For an up-and-out option, if the underlying rises to the barrier price, then the option ceases to exist. Both calls and puts cease to exist if the underlying rises to its barrier price.
Using Down-and-Out Options
Large institutions or market markers create these options by direct agreement, for the primary reason that valuing them is a complex undertaking. For example, a portfolio manager can use them as a less expensive method to hedge against losses on a long position. The hedge would be less costly than buying vanilla put options. However, it would be imperfect since the buyer would be unprotected if the security price decreased below the barrier price.
Pricing depends on all the typical options metrics with the knock-out feature adding an extra dimension. European style expirations, where the exercise may only happen at the expiration date, are complicated enough. However, an American style option, where the holder may exercise the option at any time on or before expiration, is even more complicated.