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A knock-in option is a contract term that only applies if an investment reaches a certain price level. In essence, the term "knocks in" when the conditions arise. Absent those conditions, the contract will be fulfilled as if the option does not exist. It is also known as a barrier or knock-out option. This is a high risk option with the potential to offer much higher reward than investments without a knock-in level.
Knock-in options come in four major types: down-and-in, up-and-in, down-and-out, and up-and-out. These vary by the level of the spot price, which is a commodities market price. The down-and-in and down-and-out have a spot price above the knock-in level. The up-and-in and up-and-out have spot prices below that level.
The typical knock-in option is an exotic option, which means that it is a non-standardized option meant to complement an otherwise standard investment. A standard stock option, also known as a plain vanilla option, lacks the advanced features offered by an exotic option. In some cases, the investment may be further enhanced by having two knock-in options at different price levels.
Terms outlined by the knock-in option are the determining factor in the outcome of the investment. If the knock-in level is not met, then other factors related to the performance of the investment will not be considered. This means that even if the underlying investment performs well, it does not necessarily mean that the investor will come out ahead.
With some short-term investments, a knock-in option indicates a level which the investment must reach in order for the investor to retrieve the full principal amount. This is a percentage where, if it is not reached, then the investor will receive a lower value return. This pre-established reference point is essentially the level at which risk subsides and the investment begins to pay off.
Though stocks with a knock-in option have a higher risk than plain vanilla options, they also have a lower extrinsic value. These are the elements that are used for stock valuation aside from the current price of shares. They include dividends, market volatility, interest rates, and time to expiration.
Most investors who go with the knock-out option have some assurance the underlying investment will perform well. This offsets the risk of the option. If the investment performs to expectations, it can be less expensive than the plain vanilla option.
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