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A knock-out option, also known as a barrier option, is a type of derivative security that provides the holder with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time period, as long as the price of the underlying asset does not breach a certain price level or "barrier". When the underlying asset's price crosses the barrier level, the option "knocks out" and loses value.
Whether the barrier is set above or below the current market price of the underlying asset, respectively, knock-out options can either be up-and-out or down-and-out. Traders and investors generally employ these kinds of options to reduce their possible losses in the event that the price of the underlying asset moves against their position.
Based on whether they are European or American-type knock-out alternatives, they can be further divided into subcategories. Unlike American knock-out options, which may be exercised at any time prior to expiration, European knock-out options may only be executed on the date of their expiration.
As there is a lower chance of the option being exercised due to the higher barrier level, knock-out options may be less expensive than standard options. They do, however, also carry a higher amount of risk because, even if the price of the underlying asset finally drops to a favorable level, the option may lose all of its value if the barrier is crossed.
Based on whether they are European or American-type knock-out alternatives, they can be further divided into subcategories. Unlike American knock-out options, which may be exercised at any time prior to expiration, European knock-out options may only be executed on the date of their expiration.
As there is a lower chance of the option being exercised due to the higher barrier level, knock-out options may be less expensive than standard options. They do, however, also carry a higher amount of risk because, even if the price of the underlying asset finally drops to a favorable level, the option may lose all of its value if the barrier is crossed.
