A knockout option is a type of option that will automatically expire if its underlying market hits a specific price level. This sets a cap on the potential risk associated with the options trade.
Knockout options can be bought for a smaller premium than an equivalent option without a knockout condition because they limit the profit potential for the option buyer. As such, knockout options limit both potential losses and profits.
Types of knockout options
There are two main types of knockout options, up-and-out barrier options and down-and-out options.
- Up-and-out option
An up-and-out barrier option will give the holder the right to buy or sell an underlying asset at a specific strike price if it doesn’t exceed the price barrier during the option’s lifetime. It gets knocked out if the cost of the underlying asset moves above the barrier.
Suppose an investor buys an up-and-out put stock option with a strike price of $30 and a barrier of $51. Over the option’s life, the stock hits a high of $52 but drops to $30.
The option automatically expires because the $51 barrier got breached. If the stock hadn’t gone above $51 and eventually sold off to $30, then the option remains in place with value to the owner.
- Down-and-out option
A down-and-out option gives the owner the right, but not the obligation, to buy or sell an underlying asset at a pre-set strike price, but only if the underlying asset’s price doesn’t fall below the specific barrier during the option’s life.
If the underlying asset price falls below the barrier during the option’s life, the option expires and becomes worthless.
Let’s imagine an investor purchases a down-and-out call stock option with a strike price of $45 and a barrier of $40. If the stock trades below $40 before the call option expires, then the down-and-out call option ceases to exist.The investor loses the premium they paid for the option, but nothing else.