Knock-Out Option
Candlefocus EditorKnock-out options are a type of barrier option that provide investors with the ability to regulate risk. This type of option expires worthless if the underlying asset’s price exceeds or falls below a specified price level. While the two types of knock-out options are up-and-out barrier options and down-and-out options, careful strategy must be taken to maximize potential profits.
When deciding on a knock-out option, financial advisors suggest understanding the terms of the option as well as the benefits and risks involved in the transaction. Generally, this includes the underlying asset, the option’s expiration date, the strike price, and the payout of the premium. The up-and-out knock-out option provides a long-term protection if the underlying asset goes up higher than the strike price. For the down-and-out option, the existing market protects any losses if the underlying asset's price goes lower than the option’s strike price. When investors engage in this kind of regulation of risk, they are also limiting their potential profits so they should be aware of this consequence as they make their decision.
The strike price of the knock-out option is determined at the beginning of the transaction and it is somewhat adjusted during the life of the option prior to its expiration date. If the asset's price fails to reach the knock-out level, the option does not expire and could become an exercised option. This means that the seller will have to buy the underlying asset and transfer it to the buyer of the knock-out option. As a result, the seller assumes any losses from the underlying asset, however, the seller of the option can also benefit from potential gains if the underlying asset increases by more than the exercise of the option.
When dealing with knock-out options, investors have the opportunity to manage the risk of their investments while still participating in profitable transactions. Investing in the stock market involves a certain amount of risk, however, by using a knock-out option, individuals are able to limit their losses if the market falls. Furthermore, financial advisors recommend diversifying portfolios by investing in a variety of markets and using knock-out options as an additional safety measure.