Are you puzzled by the complexity of knock-out options in investment strategies? Here’s a simple fact: a knock-out option can become worthless if an underlying asset reaches a certain price level, known as the “knock-out” price.
This blog post aims to demystify these “call knock out” options, explaining their function and how they work. Intrigued? Let’s dive into the world of exotic financial derivatives!
Key Takeaways
Table of Contents
- Call knock-out options become worthless if the underlying asset reaches a specific price level known as the “knock-out” price.
- Knock-out options have barrier levels that act as predetermined thresholds for when they become worthless, unlike traditional options.
- There are two main types of knock-out options: down-and-out and up-and-out.
- Knock-out options provide fixed risk and lower premiums but have a high chance of expiring worthless.
Understanding Knock-Out Options
Knock-out options are derivative contracts that differ from traditional options in terms of their expiration date and the price level at which they can be exercised.
Definition and key takeaways
A knock-out option is a unique type of investment. It has a set price called the ‘knock-out’ price. If this price gets hit, the option stops working and becomes worthless. You can find these options in both calls and puts.
A call knock-out lets you buy an asset until it hits a certain price. A put knock-out, on the other hand, allows you to sell your asset at a specific price until it reaches the knockout level.
This kind of option is known as a barrier option too because there’s a barrier that if crossed makes it expire. It helps protect against big losses or lock in profits within fixed prices ranges which are popular among investors and traders looking to limit risk during volatile market periods.
Differences from traditional options
Knock-out options have some key differences from traditional options. Unlike traditional options, knock-out options will expire worthless if the underlying asset reaches a specified price level called the knock-out price.
This means that if the barrier level is breached, the option terminates and no longer holds any value. Traditional options, on the other hand, can be exercised or sold until their expiration date regardless of the movement in the underlying asset’s price.
Knock-out options also have a barrier level that acts as a predetermined threshold for when they become worthless, whereas traditional options do not have this feature. Additionally, knock-out options are considered exotic options due to their complex features like barrier levels and rebates.
Types of Knock-Out Options
There are two main types of knock-out options: down-and-out and up-and-out.
Down-and-Out
A down-and-out knock-out option is a type of barrier option that will expire worthless if the underlying asset’s price falls below a certain predetermined level, known as the knock-out price.
This means that if the spot price of the asset reaches or goes below this level at any point during the option’s lifetime, the option ceases to exist and no longer holds any value.
The purpose of a down-and-out knock-out option is to provide investors with protection against significant losses by limiting their risk exposure in case the underlying asset’s price drops too much.
Up-and-Out
An up-and-out knock-out option is a type of derivative contract that becomes worthless if the underlying asset’s spot price goes above a specified barrier level before the expiration date.
This means that if the asset’s price “knocks out” or surpasses this predetermined level, the option ceases to exist. The advantage of an up-and-out knock-out option is that it allows investors to limit their risk exposure and potentially avoid large losses if the market becomes too volatile.
However, it also means that there is a chance for the option to expire without any payoff if the barrier level is breached. So, while it offers potential protection, there is also a higher risk associated with this type of option.
How Knock-Out Options Work
Knock-out options operate based on a barrier price, which if reached or exceeded, will terminate the option contract.
Barrier price and rebate
The barrier price is a specific level that, when reached, causes the knock-out option to expire worthless. It acts as a threshold that, if crossed by the underlying asset’s spot price, terminates the option contract.
The rebate is a partial or full refund of the premium paid for the option if it gets knocked out before expiration. It serves as compensation for losing out on potential gains from continuing with the option.
Barrier prices and rebates are important factors to consider when trading knock-out options since they determine whether the option will be profitable or not.
Example scenario
Let’s say you have bought a call knock-out option for Company X’s stock. The knock-out price is set at $50 per share, and the expiration date is in three months. If the stock price reaches or goes above $50 before the expiration date, your option will become worthless.
However, if the stock never reaches that level, you can exercise your right to buy the shares at a specified price. This example shows how a call knock-out option limits your risk by terminating if a certain price level is reached.
Advantages and Disadvantages of Knock-Out Options
– Pros: Lower premium and fixed risk.
– Cons: High chance of knock-out.
Pros: lower premium, fixed risk
One advantage of knock-out options is that they usually have a lower premium compared to other types of options. This means that the upfront cost of purchasing a knock-out option contract can be more affordable for investors and traders.
Additionally, knock-out options provide fixed risk, which means that the maximum potential loss is known from the beginning. This can be helpful in managing and planning for potential losses.
By paying a lower premium and having fixed risk, investors may find knock-out options to be an attractive choice when customizing their risk exposure in volatile markets.
Cons: high chance of knock-out
One downside of knock-out options is that there is a high chance of the option expiring worthless. If the underlying asset’s price reaches or crosses the pre-specified barrier level, the option will cease to exist.
This means that if the market moves against you and reaches this barrier level, you won’t be able to benefit from any potential gains in the asset’s price. This can lead to potential losses and missed opportunities for profit.
So, while knock-out options offer certain advantages, it’s important to be aware of this risk before considering them as an investment strategy.
Conclusion and Frequently Asked Questions
Call knock-out options are a type of exotic option that expire worthless if the underlying asset reaches a specific price level. They can be used by investors and traders to manage risk and limit losses in volatile markets.
Understanding how call knock-out options work, their advantages and disadvantages, is essential before considering them as an investment strategy.
FAQs
1. What is a call knock-out?
A call knock-out is a type of option pricing where the buyer’s right stops if the asset price hits a prespecified barrier level.
2. How does a reverse knockout option work?
Reverse knockout option works when an asset price hits the prespecified barrier level causing the option to cease or discontinue which could end, terminate contact or cut off connection for any further communication.
3. Are knockin options similar to call knock-outs?
Knockin options are different from call knockouts because it starts only when it reaches a set asset price unlike call knock-outs that halt communication when they hit the barrier.
4. If I am in a phone conversation and decide to stop ringing, is this also calling knocking out?
Call Knock Out means ending or finishing making a call abruptly but in finance, we use it with respect to terminating an Option contract whenever its underlying assets reach certain levels.
5. Is there any risk involved with using Call Knock-Out Option in trading?
Yes! The risks involve sudden termination of contracts upon reaching preset barriers which might not allow the buyer time for possible gains and losses.
