A knock-in option is a latent options contract that comes into effect once the underlying asset reaches a certain price before the expiration date of the contract. An options contract is an agreement between a buyer and a seller to execute a transaction to buy or sell an asset at a specified price before a predetermined date.
A knock-in option is a type of barrier option, which is an options contract where the amount that you earn depends on whether or not the underlying asset reaches a specified price level. Barrier options are either knock-in options or knock-out options. A knock-in option comprises two types – a down-and-in option or an up-and-in option.
Types of Knock-In Options
1. Down-and-In Knock-In Option
A down-and-in option occurs when the price of an asset falls to a certain price, which is called the barrier price. The options contract is activated only if the asset’s price goes below the barrier price.
An activated options contract acts like any other option by giving the option holder the right to exercise the option at the strike price before the contract’s expiration date. However, if the asset’s price does not go below the barrier price, then the options contract will not come into existence.
2. Up-and-In Knock-In Option
An up-and-in option occurs when the price of an asset reaches the barrier price, which activates the options contract. If the asset’s price never reaches the barrier price, then the options contract cannot be exercised.
Therefore, an up-and-in call option benefits the investor when the asset’s price is rising. On the other hand, a down-and-in put option benefits the investor when the asset’s price is falling.
Example of a Knock-In Option
You want to purchase a down-and-in knock-in option, with a barrier price of $10, a strike price of $20, and an asset price of $30. Note that the strike price is the price that an asset can be bought or sold at once the options contract is exercised. The strike price for a call option is the price at which the asset can be bought by the option holder. On the other hand, the strike price for a put option is the price at which the asset can be sold.
If the options contract that you are purchasing never reaches the barrier price of $10 before the expiration of the contract, then the options contract will not be activated, and it will not come into effect. However, if the options contract does reach the barrier price of $10, then the option will become a plain vanilla option with a strike price of $20. A plain vanilla option is a term that refers to a normal options contract with no special features in the contract.
In the case of a down-and-in option, the option holder has the right to sell the asset at the strike price of $20, even though the options contract may be trading at a price less than $20. However, for it to happen, the price of the asset must fall to $10 or lower before the expiration date. If it doesn’t drop to $10, then the options contract will not come into effect.
In the case of an up-and-in option, let us consider the barrier price to be $50 and the strike price to be $40. If the asset’s price reaches the barrier price of $50 or higher before the expiration date, then the options contract will be activated. If on the other hand, the asset’s price never reaches $50, then the options contract will not be activated.
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