What Is a Knock-Out Option?

A knock-out option is an option with a built-in mechanism to expire worthless if a specified price level in the underlying asset is reached. A knock-out option sets a cap on the level an option can reach in the holder's favor. As knock-out options limit the profit potential for the option buyer, they can be purchased for a smaller premium than an equivalent option without a knock-out stipulation. 

Basics of Knock-Out Options

A knock-out option is a type 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 the opposite of the knock-out. Here, the option is activated only if the underlying asset reaches a predetermined barrier price.

Knock-out options are considered to be exotic options, and they are primarily used in commodity and currency markets by large institutions. They also may be traded in the over-the-counter (OTC) market.

Key Takeaways

  • Knock-out options are a type of barrier option, which expire worthless if the underlying asset's price exceeds or falls below a specified price.
  • There are two types of knock-out options: up-and-out barrier options and down-and-out options.
  • Knock-out options limit losses, but also potential profits.

Types of Knock-Out Options

Knock-out options come in two basic types.

A down-and-out option is one variety. It gives the holder the right, but not the obligation, to purchase or sell an underlying asset at a predetermined strike price—if the underlying asset's price does not go below a specified barrier during the option's life. If the underlying asset's price falls below the barrier at any point in the option's life, the option expires worthless.

For example, assume an investor purchases a down-and-out call option on a stock that is trading at $60 with a strike price of $55 and a barrier of $50. Assume the stock trades below $50, at any time, before the call option expires. Therefore, the down-and-out call option promptly ceases to exist. 

Contrary to a down-and-out barrier option, an up-and-out barrier option gives the holder the right to buy or sell an underlying asset at a specified strike price if the asset has not exceeded a specified barrier during the option's life. An up-and-out option is only knocked out if the price 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 life of the option, the stock hits a high of $46 but then drops to $20 per share. Too bad: the option still would automatically expire, because the barrier had been breached. Now, if the stock hadn't gone above $45—if the barrier was not breached—and the stock eventually sold off to $20, then the option would remain in place and have value to the holder.

Advantages and Disadvantages of Knock-Out Options

A knock-out option may 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 also feel that the odds of the underlying asset hitting the barrier price is remote, and therefore the cheaper option is worth the risk of unlikely being knocked out of the trade. 

Finally, these types of options may also be beneficial to institutions who are only interested in hedging up or down to very specific prices or have very narrow tolerances for risk.

Pros

  • Have lower premiums

  • Limit losses

  • Good for specific hedge/risk-management strategies

Cons

  • Vulnerable in volatile markets

  • Limit profits

Knock-out options limit losses—but, as is often the case, buffers on the downside also limit profits on the upside. Also, the knock-out feature is triggered even if the designated level is breached only briefly. That can prove dangerous in volatile markets.

Real World Example of a Knock-Out Option

Let's say an investor is interested in Levi Strauss & Co.(LEVI), which went public 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.

So they may write a call option on it at $23 per share, with a strike price of $33 and a knock-out level of $43. This option only allows the option holder to profit up to $43, at which point the option expires worthlessly, limiting the loss potential for the option writer.