Knock-out options definition
A knock-out option is a type of option that expires or “knocks out” if the asset surpasses or falls below a certain price.
The knock-out options contract is active until the predetermined price is hit.
Knock-out options are one example of barrier options: options contracts with earnings dependant on whether the underlying asset reaches a specific price level, referred to as the barrier price.
Until the asset reaches the barrier price or expires, the knock-out options contract is active. If the barrier price is reached, the options contract expires prematurely.
There are two types of knock-out options:
- Down-and-out options are active until the asset dips to or below a predetermined barrier price.
- Up-and-out options give the holder the right to buy or sell an asset at a specific price if the option does not rise to or past a specific barrier price.
Knock-out options are mainly used in commodity and currency markets and can be traded over-the-counter. Premiums on these options are usually cheaper than regular options, but buyers run the risk of not realising any profits if the price target is hit.
Example of a knock-out option
An investor buys short and purchases a call option for an asset trading at £80, with a strike price of £70 and a barrier of £60. If the asset trades below £60 at any time before the call option is bought or expires, then the option is “knocked out” and expires early.