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 exceeded. 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.
Breaking Down the Knock-Out Option
A knock-out option is a type of barrier option and may be traded on the over-the-counter market. 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. Contrary to a knock-out option, a knock-in option only comes into existence if the underlying asset reaches a predetermined barrier price.
For example, an option writer may write a call option on a $40 stock, with a strike price of $50 and a knock out level of $60. This option only allows the option holder to profit up to $60, at which point the option expires worthless, limiting the loss potential for the option writer. Knock-out options are considered to be exotic options, and they are primarily used in commodity and currency markets by large institutions.
Types of Knock-Out Options
A down-and-out option is a type of knock-out option. A down-and-out barrier option 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 did 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 ceases to exist and is 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 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 gone above a specified barrier during the option's life. An up-and-out option is only knocked out if the price of the underlying asset increases above the barrier. Assume an investor purchases an up-and-out put option on a stock with a strike price of $30 and a barrier of $45. Assume the stock was trading at $40 per share when the investor purchased the up-and-out put option. Over the life of the option, the stock traded above $45, but then sold off to $20 per share. The option would automatically expire worthless. If the barrier was not breached, and the stock sold off to $20, then the option would remain in place and have value to the holder.
Reasons These Options Are Used
A knock-out may be used for several different reasons. As mentioned, the premiums on these options are typically cheaper than a similar non-knock-out option.
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.
These types of options may also be beneficial to institutions who are only interested in hedging up/down to certain levels.