What Is a Knock-Out Option? How It Works, 2 Types, Pros & Cons

What Is a Knock-Out Option?

A knock-out option is an option with a built-in mechanism to expire worthless if a specified price level in the underlying asset is reached. A knock-out option sets a cap on the level an option can reach in the holder's favor.

As knock-out options limit the profit potential for the option buyer, they can be purchased for a smaller premium than an equivalent option without a knock-out stipulation.

A knock-out can be compared with a knock-in option.

Understanding a Knock-Out Option

A knock-out option is a type of barrier option. Barrier options are typically classified as either knock-out or knock-in. A knock-out option ceases to exist if the underlying asset reaches a predetermined barrier during its life. A knock-in option is effectively the opposite of the knock-out. Here, the option is activated only if the underlying asset reaches a predetermined barrier price.

Knock-out options are considered to be exotic options, and they are primarily used in commodity and currency markets by large institutions. They also may be traded in the over-the-counter (OTC) market.

Types of Knock-Out Options

Knock-out options come in two basic types:

Down-and-Out Option

A down-and-out option is one variety. It gives the holder the right, but not the obligation, to purchase or sell an underlying asset at a predetermined strike price—if the underlying asset's price does not go below a specified barrier during the option's life. Should the underlying asset's price fall below the barrier at any point in the option's life, the option expires worthless.

For example, assume an investor purchases a down-and-out call option on a stock that is trading at $60, with a strike price of $55 and a barrier of $50. If the stock trades below $50, at any time, before the call option expires then the down-and-out call option promptly ceases to exist. 

Up-and-Out Option

Contrary to a down-and-out barrier option, an up-and-out barrier option gives the holder the right to buy or sell an underlying asset at a specified strike price if the asset has not exceeded a specified barrier during the option's life. An up-and-out option is only knocked out if the price of the underlying asset moves above the barrier.

Assume an investor purchases an up-and-out put option on a stock trading at $40, with a strike price of $30 and a barrier of $45. Over the life of the option, the stock hits a high of $46 but then drops to $20 per share. Too bad: the option still would automatically expire because the barrier of $45 had been breached. Now, if the stock hadn't gone above $45 and eventually sold off to $20, then the option would remain in place and have value to the holder.

Advantages and Disadvantages of Knock-Out Options

A knock-out option may be used for several different reasons. As mentioned, the premiums on these options are typically cheaper than a non-knock-out counterpart. A trader may also feel that the odds of the underlying asset hitting the barrier price are remote and conclude that the cheaper option is worth the risk of unlikely being knocked out of the trade. 

Finally, these types of options may also be beneficial to institutions that are only interested in hedging up or down to very specific prices or have very narrow tolerances for risk.

Knock-out options limit losses. However, as is often the case, buffers on the downside also limit profits on the upside. Moreover, the knock-out feature is triggered even if the designated level is breached only briefly. That can prove dangerous in volatile markets.

Example of a Knock-Out Option

Let's say an investor is interested in Company ABC, with a share price of $17 as of March 20. By May 2, it closed at $22.92 per share. Say our investor is bullish on the company but still cautious.

The investor may write a call option at $23 per share with a strike price of $33 and a knock-out level of $43. This option only allows the option holder (buyer) to profit as the underlying stock moves up to $43, at which point the option expires worthless, thus limiting the loss potential for the option writer (seller).

The Bottom Line

Because knock-out options limit the profit potential of the investor, they can be bought at a discount when compared to regular options. If the buyer is fairly certain that the price cap of the asset that would cause the option to expire worthless won't be reached, a knock-out option is a good choice to take in a bit of extra profit as a result of not having to pay as much in premiums.