Options & Derivatives Trading

Knockout option

What are knockout options?

A knockout option is an option with a built-in mechanism that will expire worthless if a specified price level of the underlying asset is reached. A knockout option sets a cap on the level that the option can reach in favor of the holder.

Because culling options limit the option buyer’s profit potential, they can be purchased at a smaller premium than equivalent options without culling provisions.

Knockout can be compared to the knockin option.

key takeaways

  • A knockout option is a barrier option that expires if the price of the underlying asset exceeds or falls below a specified price.
  • The two types of knockout options are up and out barrier options and down and down options.
  • Knockout options limit losses, but also limit potential profits.

Learn about knockout options

A knockout option is a barrier option. Barrier options are generally classified as knockout or knock-in. If the underlying asset reaches a predetermined hurdle during its lifetime, the strikeout option will cease to exist. The typing option is actually the opposite of typing out. Here, the option is activated only when the underlying asset reaches a predetermined barrier price.

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

Type of knockout option

There are two basic types of elimination options:

Ups and downs of choice

Ups and downs are a choice.It gives the holder the right, but not the obligation, to buy or sell the underlying asset at a predetermined strike price – if the price of the underlying asset does not rise the following Designated barriers during the life of the option. If the price of the underlying asset falls below the barrier at any point during the life of the option, the option expires worthless.

For example, suppose an investor buys a down call option on a stock trading at $60 with a strike price of $55 and a barrier of $50. If the stock trades below $50 at any time before the call expires, the downside call immediately ceases to exist.

Up and out options

Contrary to a Down Break Barrier Option, an Up Break Barrier Option gives the holder the right to buy or sell the underlying asset at a specified strike price if the asset has no Exceed Designated barriers during the life of the option. The upside option will only be cancelled if the price of the underlying asset is above the barrier.

Suppose an investor buys a put option on a stock at $40 with a strike price of $30 and a barrier of $45. The stock hit a high of $46 during the life of the option, but has since fallen to $20 a share. Too bad: options still automatically expire due to the $45 barrier being breached. Now, if the stock doesn’t go above $45 and ends up being sold to $20, the option will live on and have value to the holder.

Pros and cons of knockout options

The knockout option may be used for several different reasons. As mentioned earlier, the premiums for these options are generally cheaper than non-knockout options. A trader may also consider the odds of the underlying asset hitting the barrier price low and conclude that the cheaper option is worth the risk of being less likely to be knocked out.

Finally, these types of options may also benefit institutions that are only interested in hedging very specific prices or have a very narrow tolerance for risk.

Knockout options limit losses. Typically, however, downside buffers also limit upside profits. In addition, even briefly breaking the specified level will trigger the elimination feature. In volatile markets, this can be dangerous.

Knockout option example

Suppose an investor is interested in Levi Strauss & Co., which went public on March 21, 2019 at $17 per share. On May 2, it closed at $22.92 a share. Let’s say our investors are bullish on the venerable jeans maker but remain cautious.

Investors can sell a call option with a strike price of $33 and a strikeout level of $43 at $23 per share. This option only allows the option holder (buyer) to profit when the underlying stock rises to $43, at which point the option expires worthless, limiting potential losses to the option seller (seller).

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