A knock-out option is an options contract that will become worthless if the investment reaches a specific price. In such a case, the options contract is “knocked out,” and the investor will not receive a payoff. An options contract refers to an agreement between a buyer and a seller to buy or sell an asset by an expiration date at a certain price.
A knock-out option is the opposite of a knock-in option. It is a type of barrier option, which is a type of options contract where the payoff of the investment depends on the asset’s ability to reach a certain price specified in the contract.
Since knock-out options can potentially become worthless, they are usually sold at a small discount compared to a plain vanilla option, which is a type of options contract that does not include special terms in the contract. It only gives the investors the right to buy or sell at a predetermined price on a specific date.
Types of Knock-Out Options
1. Down-and-Out Knock-Out Option
A down-and-out option is a type of knock-out option that gives the right for the option holder to buy or sell the underlying asset in the options contract at the strike price. This is valid as long as the asset’s price does not go below a certain price specified in the contract, called the barrier price. In the case where the asset’s price does reach the barrier price and it falls below it, then the option contracts will be considered worthless, and is knocked-out.
Note that a strike price refers to a specific price written in the options contract that allows the asset to be bought or sold at that particular price once the contract is exercised.
2. Up-and-Out Knock-Out Option
An up-and-out option is a type of knock-out option that gives the right for the option holder to buy or sell the asset in the options contract at a specific price, only when the asset’s price does not go higher than the barrier price.
In such a case, the asset can be bought or sold at the strike price. However, if the asset’s price does go higher than the barrier price, then the options contract will also be considered worthless, and is knocked-out.
Example of a Knock-Out Option
For a down-and-out option, you purchase a knock-out option with a barrier price of $50, a strike price of $70, and an asset price of $60. If the asset’s price never reaches the barrier price of $50 and does not go below it before the expiration date, then the options contract can be exercised, and the investor will receive a payoff.
As long as the asset’s price never reaches the barrier price, then the investor is allowed to sell the options contract at the strike price of $70, no matter what the asset’s price is at the time of selling. On the contrary, if the asset’s price falls down to $50 or below before it expires, the options contract will be deemed worthless.
In the case of an up-and-out option, if we assume that the barrier price is $70, the strike price is $60, and the asset price is $50. If the asset’s price never goes up high enough to reach the barrier price of $70 and does not go above it before the expiration date, then the options contract will still be valid and can be exercised.
However, if the asset’s price exceeds the barrier price of $70 before the expiration date, the options contract is “knocked-out”, cannot be exercised, and will be considered worthless.
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