Knock-Out Option

Definition: What is a Knock-Out Option?

A Knock-Out Option, in the world of trading, is a form of derivative that terminates or "knocks out" if it reaches a certain price barrier. This predetermined price level is typically set above the spot price in a call option and below the spot price in a put option. When this price level is touched or surpassed, the Knock-Out Option becomes worthless, hence the name "Knock-Out".

Types of Knock-Out Options

There are two types of Knock-Out Options: the Up-and-Out Option and the Down-and-Out Option. The Up-and-Out Option becomes worthless if the underlying stock's price goes above the barrier price, while the Down-and-Out Option becomes worthless if the underlying stock's price drops below the barrier price. These types allow traders to speculate on how a security will perform within a certain price range.

How does a Knock-Out Option work?

When a trader acquires a Knock-Out Option, they're betting that the underlying asset will not reach the knock-out barrier. If the knock-out barrier is not breached, the option works like a normal option allowing the holder to buy (in case of a call option) or sell (in case of a put option) the underlying asset at an agreed-upon price. However, once the knock-out barrier is hit, the option expires immediately and the trader loses the premium paid for the option.

Benefits and Drawbacks of Knock-Out Options

Knock-Out Options can protect traders from sudden, unfavorable price excursions while keeping the risk limited to the premium paid. They're an efficient way to hedge against risk and are typically cheaper than standard options due their limited lifespan.
Yet, the risk of losing the entire premium if the knock-out barrier is hit, poses high risk to the investor. Furthermore, predicting the future price of an underlying asset and setting an appropriate knock-out barrier can be difficult and requires careful analysis and consideration.

Does a Knock-Out Option Suit Everyone?

Knock-Out Options are best suited for experienced traders who understand the dynamics of the market and are able to take on a certain level of risk. They are complex instruments that require a good understanding of options and trading strategies. So, novice traders should gain more experience and understand the risks before considering Knock-Out Options.