A knock-out option is a type of option that is rendered worthless if the price of the security underlying the option goes above or below a predetermined price level. If that occurs, the option is knocked out, and it no longer matters what the price of the underlying security does. The knock-out option is one particular type of barrier option, which generally comes at a bit of a discount to investors compared to so-called vanilla options. This is because this type of option becomes worthless at a time when other options start to become extremely profitable.
Options are investment vehicles which allow investors to speculate on the price of an underlying security without gaining physical ownership of that security, although they may eventually own the security in the transaction. Buyers of options pay a price known as the premium for the option, which may be exercised if the price reaches a predetermined strike price, a status also known as being in the money. If the underlying security fails to go in the money before the option expires, the contract is worthless. With a knock-out option, a second price level comes into play that makes the option worthless even if it is in the money.
As an example of how a knock-out option works, imagine that a buyer purchases an option to buy, also known as a call option, a security currently priced at $90 US Dollars (USD) if it reaches a strike price of $100 USD. The option seller, or writer, adds a knock-out barrier of $120 USD. That means that, even if the price goes above the strike price of $100 USD, the option will be worthless once the price reaches $120 USD.
This example illustrates the perils of buying a knock-out option. It it were a vanilla option with no barrier, the option would become extremely profitable for the buyer if it headed over the $120 USD barrier and beyond. Such an example shows the reason why barrier options are cheap compared to vanilla options, since the underlying security in a barrier option has to settle into a window of prices, neither too high nor too low, for it to work out for the buyer.
The opposite of the knock-out option is the knock-in option, which allows the buyer to exercise no matter what the underlying security price does after that barrier is reached. Knock-out options are one way that an option writer can protect from big losses. By setting the barrier at a reasonable amount, it keeps the option from going too far in the money.