Knock Out Option - Explained
What is a Knock Out Option?
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Table of ContentsWhat is a Knock-Out Option?How Does a Knock-Out Option Work?Types of Knock-Out OptionsReasons These Options Are Used
What is a Knock-Out Option?
A knock-out option is an option contract that will automatically expire even before the set expiration date arrives when a specified price level of underlying asset is reached. This option sets a cap on the price level a contract option can reach to ensure that a price disadvantageous to the option writer is not reached. Knockouts will end up with the option holder losing the premium, which are normally cheaper than in other options, but some knock-out options refund the lost premiums.
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How Does a Knock-Out Option Work?
Knock-out options come as barrier options traded on OTC markets. Barrier options can either be knock-out or knock-in options. Knock-out options will expire when a predetermined price is reached while knock-in options will start existing when a predetermined price level is arrived at. Suppose an option writer writes a contract option on a $60 stock with a $70 strike price and a $80 knock-out level. In such a case, the option holders profits are up to $80. At $80, the option expires. These options are common in Forex markets.
Types of Knock-Out Options
There are two types of knock-out options; a down-and-out and up-and-out options. Down-and-out options give the holder the right to buy or sell an asset at a specified strike price if the price of the asset goes below a predetermined barrier. Whenever the price of the asset goes below the set barrier, the option expires. Suppose an option writer writes a down-and-out option for a stock trading at $80 with a strike price of $75 and a barrier set at $70. If the price of the asset falls to $70 before the option expires, the down-and-out option will cease to exist. Up-and-out options lets the holder purchase or sell an asset at a given strike price if the price of the asset does not exceed the specified barrier before it expires. If the price of the asset increases above the barrier, the up-and-out option ceases to exist.
Reasons These Options Are Used
Knock-out options are preferred by investors because their premiums are cheaper and therefore less risky. Investors are sure that they will not be completely knocked out of trade. The options are also used by institutions that only need to hedge up or down to a specified price level.