Knock-Out Option

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What is Knockout Option?

Knock-out price decides the level of options contract that the buyer or seller (writer) can hold. A knock-out option is a derivative contract in an option, which loses its entire value if the underlying asset's price reaches a certain level and the option contract expires worthless. In such a case, the buyer does not get a payoff, and the option writer receives a fixed payoff if the underlying price reaches a certain level.

What is Knockout Option?

A knockout option diminishes in value when the underlying asset's price reaches a specific level, and the option contract becomes worthless. The writer receives a fixed payoff if the underlying price achieves this level, shifting the buyer's and writer's risk dynamics.
The knockout option landscape includes down-and-out and up-and-out options, each incorporating barriers that trigger value loss when asset prices surpass predetermined thresholds.
Knockout options hold appeal in commodity and currency markets due to their cost-effectiveness. They cater to traders seeking profit in less volatile markets, presenting a more economical alternative to standard exchange-traded options.

Example

Stock X trading at $200 per share, an investor decides to buy a call option of strike $210 with a knockout price of $220 at $2. In the plain vanilla call option of a strike, $210 is at $5. The buyer is bullish on the stock but doubts that the price level will cross above $220. If by the expiry of that option, the contract price of the stock reaches the level of $220, then the option contract will expire worthlessly. If it does not hit $220, then the option continues to be valid until the expiry of the contract.

Scenario 1: The stock price of X remains below $210. In this case, the Knock-out call option buyer will face a loss of $2, and regular option buyers will face a loss of $5 since the call strike becomes out of money.
Scenario 2: The stock price of X is above $210 but not above $220. In this case, the knockout option buyer will benefit more since the price paid to buy a call of $210 is $2 compared to the regular option buyers.
Assume if the stock price of X by the end of the options contract period is $218, then the regular option buyer will get a profit of $3 ($218-$210-$5=$3), and the Knockout option buyer will receive a profit of $6 ($218-$210-$2=$6)
Scenario 3: The stock price of X crosses $220, the knockout option ceases to exist, while the regular option trader will continue to receive profit per price.
Assuming X's stock price is $250, then a regular call option buyer of $210 at $5 will get a profit of $35 ($250-$210-$5=$35).

Process

Barrier Options:

Knockout Option: If the underlying asset price crosses a predetermined price, the option contract becomes worthless.
Knock-in Options: Option contracts become valid and come into existence only after the price of an underlying asset reaches a certain price.

Knockout options are traded in the over the counter (OTC) market, mostly used by large businesses to manage their positions in commodity and currency markets. Only in the case of the money option contract is there a positive payoff if the option strike is in the money at the expiry and the underlying asset does not breach the underlying asset.

Why would the buyer Prefer to Buy a Knockout Option?

This is cheap in comparison with plain vanilla options traded on the exchange.
In international business, such an option is used to achieve small profits instead of speculating major movements within the life of trade.
Since the knockout option contract is customized, it can be adjusted per individual needs compared to exchange-traded option contracts, where an exchange regulates terms.

Types

#1 - Down and Out Options

An option contract gives the right but not obligation to buy or sell the underlying asset at a certain price only if the price of an asset does not fall below the given price barrier during the option contract period.

Example

The stock price of Stock XYZ is $100. The buyer decides to buy a call option of strike $90, while the barrier on the downside of the stock is $80. Before the expiry of an option contract, if Stock XYZ touches the $80 price, this call option will expire worthlessly.

#2 - Up and Out Options

An option contract gives the right but not the obligation to buy or sell the underlying asset at a certain price only if the price of an asset does not go above the certain barrier of price during the option contract period.

Example

Stock XYZ is trading at $100. The buyer decides to buy a put option of strike $90 with a barrier on the upside is $120. If within the life of the options contract the underlying asset does not cross the price of $120, the option contract continues to be valid; otherwise, it expires as worthless.

Difference between Knock-out Options and Knock-in Option

Particulars	Knockout Option	Knock-in option
Definition	Options contracts expire as worthless if the price of an underlying asset reaches a certain price.	An option contract will exist only if an underlying asset's price reaches a certain price.
Good for	Beneficial for speculators.	Beneficial for hedgers and speculators.
Expectation	An underlying asset will not breach certain price levels.	Certain Price levels need to be breached to activate knock-in options.
Risk	In the case of a major movement in the market, a knockout option will be worthless.	If there is stagnating or downward movement in the market, Knocking on options will not make any sense.

Advantages

Limited Cash Outflow: Compared to other option contracts, cash flow payout is very less, resulting in a limited loss if the trade is not executed as per expectation.
Tailor-made Contracts: Knockout options traded in the OTC market; helps personalize option contracts so they can be made as per requirement.

Disadvantages

High volatility risk: Traders need to analyze risk in the up and downside since, in case of major movement, traders will lose an opportunity or might face loss.
No Hedging opportunity: Traders who prefer to hedge their positions with options to avoid major loss might face a huge loss in case of major movements against the trade, and such an option might be worthless.
OTC Contracts: For a regular trader, such an option is not available since it is available in the OTC market.
Lack of liquidity and regulator in a contract: There is a risk of default in the case of OTC contracts since both parties depend on each other for trust. The knockout option has very little or almost no liquidity since it is tailor-made per an individual's need.

Conclusion

Knockout options are highly preferable for commodity and currency markets because of their features. In less volatile market speculators who still want to generate profit, such options are a better choice since the price is comparatively lower than the regular exchange-traded option. At the same time, terms and periods can be customized.

Frequently Asked Questions (FAQs)

1. What is the importance of the knockout option?

Knockout options play a crucial role in risk management by limiting potential losses for traders and investors. These options have a predetermined barrier level, and if the underlying asset's price reaches or breaches this level, the option "knocks out," rendering it worthless. This feature allows traders to control their risk exposure, especially in volatile markets, as they can define a point beyond which their option won't incur further losses.

2. What are the risks of knockout option?

While knockout options offer risk mitigation, they also come with limitations. The primary risk lies in the possibility of the underlying asset's price hitting the barrier level, leading to the option's immediate expiration. This risk can result in missed opportunities if the asset's price subsequently moves favorably.

3. What is the knockout vs. reverse knockout option?

A knockout option features a predetermined barrier that, if reached, invalidates the option. Conversely, a reverse knockout option, also known as a knock-in option, becomes active only when the underlying asset's price reaches a specified barrier level. In a knockout option, breaching the barrier reduces risk, while in a reverse knockout option, crossing the barrier increases risk.