What it means
An ordinary option gives the holder the right, but not the obligation, to buy or sell an asset at a fixed price (the strike) before a given date. A knock-in option adds a barrier, which is a price level that must be reached before the option activates.
If the barrier is never touched during the life of the option, it expires worthless. There are several versions.
An up-and-in option activates when the price rises to a barrier above the starting price, while a down-and-in option activates when it falls to a barrier below the starting price. Each can be a call, giving the right to buy, or a put, giving the right to sell.
Buyers choose knock-in options because they want protection or exposure only in specific scenarios, and are happy to pay less for it. For example, a company might want a currency hedge that only starts if the exchange rate moves to a worrying level.
Since the option may never activate, the premium is lower than for a standard option. The risk is that the option may not be there when it is needed.
If the price moves in the wrong direction and never touches the barrier, the buyer receives nothing, and the premium is lost. This is why a knock-in option is better suited to someone with a clear view about where prices may go, and not to a general safety net.
Barrier options are known as exotic options, because they are more complex than standard contracts. They are usually traded over the counter, meaning directly between a client and a bank rather than on an exchange.
Terms such as how the barrier is monitored can vary, so the contract must be read carefully. Valuation relies on models that account for the chance of reaching the barrier, and prices respond to volatility.
Corporate treasuries should be careful about the accounting and the risk that they may not understand the product well. Many organisations have policies that limit the use of exotic options for this reason.
In practice
Real-world examples.
Example
An importer expects a currency to weaken a little but wants protection only if it falls sharply. She buys a down-and-in put on the currency with the barrier at a level that signals real trouble. The premium is lower than for a standard put, which suits her budget.
Example
A fund manager believes a commodity will break through a resistance level and then rally. He buys an up-and-in call that activates at that level. The lower cost allows him to buy a larger position than with a regular option.
Example
A bank structures a savings product for clients that includes a knock-in put on a share index. If the index falls to the barrier, clients bear losses on the underlying amount. Clients receive a higher return in normal conditions as compensation.
Formula
Calculation
Payoff of a knock-in call at expiry = (final price - strike) per share if the barrier was touched and the final price is above the strike, otherwise 0. Profit = payoff - premium paid.
Suppose an investor buys an up-and-in call on 1,000 shares with a strike of $50 and a barrier of $55, paying a premium of $2 per share, or 1,000 x 2 = $2,000. The share price rises to $55 during the period, activating the option, and finishes at $60. The payoff is (60 - 50) x 1,000 = $10,000, so the profit is 10,000 - 2,000 = $8,000. If the price had never reached $55, the option would have expired worthless and the loss would be the $2,000 premium.Case study
Seen in the real world.
Coastal Freight is an illustrative, fictional shipping company that wanted protection against a sharp rise in fuel prices. A standard call option would have cost $90,000, which the board found too expensive for a risk it considered unlikely.
The treasurer arranged an up-and-in call that activated only if fuel reached a price 15% above the current level. The premium was $50,000, saving $40,000, and the company accepted that it would be unprotected against a smaller rise.
Fuel eventually did spike beyond the barrier, the option activated and the payoff covered most of the extra cost. The illustrative lesson was that the lower premium was a trade-off, and the board had to be comfortable with the unprotected range before approving the contract.
Watch out
Common mistakes.
- Assuming a knock-in option always pays out, when it is worthless if the barrier is never reached.
- Choosing it only because of the lower premium, without considering the gap in protection before the barrier is hit.
- Not reading how the barrier is observed, since some contracts use continuous monitoring and others check only at set dates.
Questions
People also ask.
How does a knock-in option differ from a regular option?
A regular option is active from the start, whereas a knock-in option only becomes active once the underlying price touches the barrier.
Why is it cheaper?
Because there is a chance it never activates, the seller takes less risk and therefore charges a lower premium.
What is the opposite of a knock-in option?
A knock-out option, which exists at the start and ceases to exist if the barrier is reached.
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