Knock-Out Option

Introduction

A knock-out option is a type of financial derivative that has a predefined price barrier. If this barrier is breached at any time during the life of the option, the option is terminated and becomes worthless. Knock-out options belong to a broader category of exotic options called barrier options, which are more complex compared to standard vanilla options. These options are particularly useful in hedging strategies and in scenarios where investors believe the price of the underlying asset will not reach certain levels.

Types of Knock-Out Options

Knock-out options are primarily divided into two types:

1. Up-and-Out Options

An up-and-out option is a type of knock-out option that terminates if the price of the underlying asset rises above a specified barrier level. For example, consider a call option with a strike price of $50 and a barrier level of $70. If the underlying asset’s price rises above $70 at any time during the option’s life, the option ceases to exist.

2. Down-and-Out Options

A down-and-out option is a knock-out option that becomes void if the price of the underlying asset falls below a specified barrier. For instance, consider a put option with a strike price of $50 and a barrier level of $30. If the underlying asset’s price drops below $30 at any time during the option’s term, the option is nullified.

Key Components of Knock-Out Options

1. Underlying Asset

The underlying asset in a knock-out option can be any tradable asset such as stocks, commodities, indices, or foreign exchange rates. The value of the knock-out option is intrinsically linked to the price movements of this underlying asset.

2. Strike Price

The strike price is the predetermined price at which the holder of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.

3. Barrier Level

The barrier level is the price point at which the knock-out option becomes void. This is a key component that differentiates knock-out options from other types of options.

4. Expiry Date

The expiry date is the date on which the option will expire if the barrier level is not breached. On this date, if the barrier has not been breached, the option can be exercised or settled based on its intrinsic value.

5. Premium

The premium is the price paid by the buyer to the seller to acquire the knock-out option. Typically, knock-out options have lower premiums compared to standard options because of the added risk associated with the barrier level.

Pricing of Knock-Out Options

The pricing of knock-out options is more complex than standard options due to the additional barrier condition. Several factors affect the pricing of these options:

1. Volatility

Higher volatility of the underlying asset increases the likelihood of the barrier being breached, which generally leads to a lower premium for the knock-out option.

2. Time to Expiry

The longer the time until expiry, the higher the probability that the barrier might be breached. Therefore, knock-out options with longer expiries tend to have lower premiums.

3. Distance to Barrier

The distance between the current price of the underlying asset and the barrier level significantly impacts the option’s price. A barrier that is far from the current price reduces the likelihood of the option being knocked out, thus increasing the premium.

4. Interest Rates

Prevailing interest rates can also influence the pricing of knock-out options. Higher interest rates typically increase the cost of holding the position, which can affect the option’s premium.

5. Dividends

For options on stocks, the expected dividends during the life of the option can impact its pricing. Paid dividends can lead to price drops in the underlying stock, possibly affecting the likelihood of breaching the barrier.

Use Cases of Knock-Out Options

Knock-out options are used in various financial strategies:

1. Hedging

Investors use knock-out options to hedge their portfolios against adverse price movements. For instance, an investor holding a portfolio of stocks might buy a down-and-out put option to protect against a significant drop in the market.

2. Speculation

Traders use knock-out options to speculate on the future direction of an asset’s price with reduced premium costs compared to standard options. The built-in barrier level allows for lower upfront costs, which can result in higher leverage and potential returns.

3. Yield Enhancement

Some investors use knock-out options to enhance the yield on their investments. By writing knock-out options (selling), they earn premium income while taking on the risk that the option could be exercised if the barrier is not breached.

Example in Real-World Trading

Consider an investor who believes that the price of an oil company stock, currently trading at $50, will increase but not exceed $80 within the next six months. The investor could purchase an up-and-out call option with a strike price of $60 and a barrier level of $80. If the stock price rises to $75 but does not exceed $80, the investor can still exercise the option and profit from the price difference. However, if the stock price goes above $80, the option is knocked out, and the investor loses the premium paid for the option.

Risk Management

1. Barrier Breach

The primary risk of knock-out options is the possibility of the barrier being breached, which renders the option worthless. Investors must carefully consider the likelihood of this event when selecting the barrier level.

2. Market Conditions

Market conditions such as volatility, liquidity, and economic events can drastically affect the price movements of the underlying asset, impacting the likelihood of the barrier being breached.

3. Moneyness

The moneyness of knock-out options—whether they are in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM)—can significantly affect their risk and reward profile. For example, out-of-the-money knock-out options have a higher risk of breaching the barrier but can be more cost-effective.

Regulatory Considerations

Knock-out options are subject to regulatory standards depending on the jurisdiction. Regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) and the European Securities and Markets Authority (ESMA) oversee the trading and offering of these derivatives to ensure fair practices and protect investors.

Major Market Participants

Refinitiv

Refinitiv offers various tools and platforms for trading derivatives, including knock-out options. They provide market data, analytics, and trading systems that help traders make informed decisions. Refinitiv

CME Group

The CME Group is one of the world’s largest exchanges for trading futures and options, including exotic options like knock-out options. They offer a wide range of products across various asset classes. CME Group

Saxo Bank

Saxo Bank provides a comprehensive trading platform that supports various derivatives, including knock-out options. They offer advanced tools and analytics for options trading. Saxo Bank

Conclusion

Knock-out options offer a unique set of features that can be advantageous for both hedging and speculative purposes. Their lower premiums make them an attractive choice for investors looking to manage risk with limited capital. However, the embedded barrier condition introduces additional risks, making it crucial for traders and investors to thoroughly understand these instruments before engaging in knock-out options trading.