Knock-Out Option Definition
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.
A Little More on What is a Knock-Out Option
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 holder’s 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.
References for Knock Out Option
Academic Research on Knock-in or Out Option
- Risk Management Lessons from ‘Knock‐in Knock‐out‘Option Disaster, Khil, J., & Suh, S. (2010). Asia‐Pacific Journal of Financial Studies, 39(1), 28-52. This paper looks at an instance where the current knock-in knock-out system failed in Korea during the 2007-08 financial crises. The hedging instruments and investors lost a lot of money. This paper analyzes the events that occurred during that period and how losses would have been prevented through risk assessment and management. The author notes that, if the investors had assessed the risk using standard measures such as value-at-risk, they would have reduced the losses. The paper concludes that, hedging-and-forgetting is not a viable investment model. If the investors in Korea had continuously assessed and managed their risks, losses would have been mitigated.
- Pricing double barrier options using Laplace transforms, Pelsser, A. (2000). Finance and Stochastics, 4(1), 95-104. This paper is an analysis of double barrier options and how investors can use these options to maximize their profits. It develops a formula that investors can use when deciding the barrier options to go for. It also expounds more on barrier options such as double knock-in options.
- Altering the terms of executive stock options, Brenner, M., Sundaram, R. K., & Yermack, D. (2000). Journal of Financial Economics, 57(1), 103-128. This paper examines how the terms of executive stock options can be reset. It explains different options available for investors and shows a simple model investor can use to value reset options. It also looks at different firms that offer reset options. The author observes that resetting does not significantly affect the ex-ante value of options but its effects on the ex-post value are significant.
- Pricing parisian options, Haber, R. J., Schönbucher, P. J., & Wilmott, P. (1999). Journal of Derivatives, 6, 71-79. This paper examines hedging and barrier options. It takes a case of Paris and develops a model that investors and hedge managers can use to enhance trade.
- Pricing and Hedging Double‐barrier Options: A Probabilistic Approach, Geman, H., & Yor, M. (1996). Mathematical finance, 6(4), 365-378. This paper is an analysis of barrier options and how they are applied in markets. It shows how these options are used in risk management strategies. The author analyzes different studies to expound more on the literature of barrier options. It concluded by suggesting a model on the use of barrier options effectively.
- Pricing and hedging path-dependent options under the CEV process, Davydov, D., & Linetsky, V. (2001). Management science, 47(7), 949-965. This paper examines path dependent options with the view that existing work assumes that these options show constant volatility. The author develops a formula that can be used to determine the prices of options.
- Knock‐in American options, Dai, M., & Kwok, Y. K. (2004). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 24(2), 179-192. In this paper, the author expounds more on what Knock-in American options are. The author develops analytic valuation formula for these options to help investors value options before setting barriers.
- Pricing Parisian-style options with a lattice method, Avellaneda, M., & Wu, L. (1999). International Journal of Theoretical and Applied Finance, 2(01), 1-16. The author explains how a Parisian style option works. The option will expire when an underlying asset’s price stays above or below a given level(s) for a predetermined period/window. It develops a scheme that can be used to value Parisian style options.
- On pricing of discrete barrier options, Kou, S. G. (2003). Statistica Sinica, 955-964. This paper examines discrete barrier options and observes that these are options that expire or are activated when the price of underlying asset goes below or above a certain level. The models will assume that the options are continuously monitored but they are only discretely monitored.
- Using Brownian bridge for fast simulation of jump-diffusion processes and barrier options, Metwally, S. A., & Atiya, A. F. (2002). Journal of Derivatives, 10(1), 43-54. This paper offers a Monte Carlo barrier pricing model in cases where underlying assets follow jump diffusion process with continuously monitored barriers and constant parameters. It shows the different algorithms that are applied in barrier options and concludes by showing different applications of the Monte Carlo model.
- Valuing moving barrier options, Rogers, L. C. G., & Zane, O. (1997). Journal of Computational Finance, 1(1), 5-11. This paper shows investors how to value options knocked out in cases where prices cross moving barriers. This valuing method reduces the problems experienced with fixed barriers.
- Closed form valuation of American barrier options, Haug, E. G. (2001). International Journal of Theoretical and Applied Finance, 4(02), 355-359. This paper examines closed form valuation for European barrier options and compares that with American barrier options. It shows that there is no published American closed form valuation and investors use numerical methods. It shows that while there are many authors who aim at improving valuing algorithms, the algorithms still use numerical methods. The paper shows how investors in America can analytically value barrier options to speed up the valuation process.