What is Knockout Option?

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 contractOptions ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more 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).

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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 counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don’t hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more (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 assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more.

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.

Stock XYZ is trading at $100. The buyer decides to buy a put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more 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

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 marketOTC MarketOTC markets are the markets where trading of financial securities such as commodities, currencies, stocks, and other non-financial trading instruments takes place over the counter (instead of a recognized stock exchange), directly between the two parties involved, with or without the help of private securities dealers.read more; 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 HedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more 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 defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more 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 marketsCurrency MarketsFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange.read more because of their features. In less volatile market speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more 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.

This has been a guide to what is Knockout Options? Here we discuss examples, types, why buyers prefer to buy knockout options, and advantages and disadvantages. You may learn more about financing from the following articles –

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