What is Knock-Out Option?
369 reads · Last updated: December 5, 2024
A knock-out option is an option with a built-in mechanism to expire worthless if a specified price level in the underlying asset is reached. A knock-out option sets a cap on the level an option can reach in the holder's favor.As knock-out options limit the profit potential for the option buyer, they can be purchased for a smaller premium than an equivalent option without a knock-out stipulation.A knock-out can be compared with a knock-in option.
Definition
A knock-out option is a type of option with a built-in mechanism that automatically becomes void if the underlying asset reaches a specified price level. It sets a cap on the level the option can reach in favor of the holder. Because knock-out options limit the profit potential for the option buyer, they can be purchased at a lower premium compared to equivalent options without the knock-out provision. Knock-out options are contrasted with knock-in options.
Origin
Knock-out options originated from the development of financial derivatives markets, designed to provide investors with more risk management tools. As the options market matured, the demand for customization and risk control increased, leading to the creation of knock-out options.
Categories and Features
Knock-out options are mainly divided into two types: up-and-out options and down-and-out options. An up-and-out option becomes void when the underlying asset's price reaches or exceeds a certain level, while a down-and-out option becomes void when the price falls to or below a certain level. Their main feature is that they limit the potential gains for the option holder but also reduce the cost of purchasing the option.
Case Studies
Case Study 1: Suppose an investor buys an up-and-out option with the underlying asset being a tech company's stock, with a knock-out price of $150. When the stock price reaches $150, the option automatically becomes void, and the investor can no longer profit from further price increases. Case Study 2: Another investor buys a down-and-out option with the underlying asset being an energy company's stock, with a knock-out price of $50. When the stock price falls to $50, the option becomes void, and the investor can no longer profit from further price decreases.
Common Issues
Common issues investors face include: Is a knock-out option suitable for all investors? Typically, knock-out options are suitable for those who wish to lower the cost of options and are willing to accept potential profit limitations. Another common misconception is that knock-out options are always more advantageous than regular options, but in reality, they simply offer a different risk-reward balance.
