What it means
An ordinary option gives its holder the right, but not the obligation, to buy or sell an asset at a fixed price (the strike) on or before a given date. A knock-out option adds a barrier, a price level that cancels the contract if it is reached.
As long as the barrier is never touched, the option behaves like a normal one until expiry. There are two main directions.
An up-and-out option is cancelled when the price rises to a barrier above the starting level, and a down-and-out option is cancelled when it falls to a barrier below. Each can be a call, which gives the right to buy, or a put, which gives the right to sell.
The reason people buy them is cost. Since there is a chance that the option will be cancelled, the seller takes less risk and charges a lower premium.
A buyer who is confident that the price will move in one direction but not too far can save money by accepting the cancellation risk. Companies sometimes use knock-out options to hedge currency or commodity exposure at lower cost.
A business that needs protection against a moderate fall in a currency, but believes a collapse is very unlikely, might buy a down-and-out put with the barrier set well below the current rate. The drawback is that protection vanishes just when the move is largest.
That cancellation feature is the central risk to understand. Someone who holds a down-and-out call can see the price dip briefly through the barrier, lose the option, and then watch the price recover without any benefit.
The way the barrier is monitored, continuously or only at set times, is therefore a vital term in the contract. Knock-out options are exotic options, meaning they are more complex than standard contracts, and they are usually traded directly between a client and a bank.
Valuation depends on models that estimate the chance of touching the barrier. Treasury teams should confirm that their policies, accounting and expertise are suited to such instruments before using them.
In practice
Real-world examples.
Example
An exporter expects the dollar to fall a little against her currency but not drastically. She buys a down-and-out put with the barrier far below the current rate to protect her sales. The premium is much lower than for a standard put, which fits her hedging budget.
Example
A fund manager believes a commodity will rise gently over the next quarter. He buys an up-and-out call with a barrier well above his target price, saving money compared with an ordinary call. If the commodity spikes past the barrier, the option is cancelled, which he accepts as the price of the discount.
Example
A bank sells a structured investment note to clients that includes a knock-out feature on a share index. If the index stays below the barrier, clients receive an enhanced return. If it rises past the barrier, the extra return is cancelled and clients receive only their money back.
Formula
Calculation
Profit of a knock-out call = (final price - strike) x number of shares - premium paid, provided the barrier was never touched. If the barrier was touched, the option is cancelled and the loss is the premium.
Suppose an investor buys a down-and-out call on 500 shares with a strike of $100, a barrier of $85 and a premium of $4 per share, or 500 x 4 = $2,000. If the price never falls to $85 and finishes at $115, the payoff is (115 - 100) x 500 = $7,500, so the profit is 7,500 - 2,000 = $5,500. If the price dipped to $85 at any point, the option would be cancelled and the loss would be $2,000, even if the price then recovered to $115.Case study
Seen in the real world.
Highland Grain is an illustrative, fictional food manufacturer that wanted to protect against a rise in wheat prices. A standard call option on 10,000 tonnes would have cost $120,000, and the finance director thought that was too much for a risk she saw as moderate.
She arranged an up-and-out call with a barrier 25% above the current price at a premium of $70,000. The saving of $50,000 came from accepting that if wheat rose very sharply, the protection would end.
Wheat did rise by 30% during the year, passing the barrier, and the option was cancelled while the company faced the highest costs. The illustrative lesson was that the cheaper premium bought protection only in the range where it was least needed, and the board should have understood this before approving the hedge.
Watch out
Common mistakes.
- Assuming a knock-out option gives the same protection as an ordinary option, when it can disappear at exactly the moment the market moves furthest.
- Focusing on the lower premium without checking how and when the barrier is monitored.
- Believing that a price recovery after a barrier is touched brings the option back, when the cancellation is permanent.
Questions
People also ask.
What is the difference between a knock-in and a knock-out option?
A knock-in option only starts when the barrier is touched, while a knock-out option exists at the start and is cancelled when the barrier is touched.
Why is a knock-out option cheaper than a standard option?
The seller may not have to pay out if the barrier is touched, so the risk is lower and the premium is reduced.
Who uses knock-out options?
Companies hedging currency or commodity costs, fund managers expressing a view and banks building structured products, usually in the over-the-counter market.
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