A knock-out option is a derivative contract that automatically expires worthless if the underlying asset reaches a specific predetermined price level.
Mechanics of knock-out options
These options are traded over-the-counter in global financial markets and are common in forex and commodity trading. A knock-out option operates with a standard strike price and an expiration date. The contract includes an additional price level known as the barrier. If the underlying asset touches the barrier price at any point before expiration, the option is immediately canceled.
The market categorizes these contracts into two types. An up-and-out option is nullified when the asset price rises to the barrier level. A down-and-out option is canceled when the asset price falls to the barrier level. Once the underlying asset hits the designated barrier, the option holder loses the premium paid to open the trade. The contract remains void even if the asset price subsequently reverses direction.
Elephants trade knock-out options because the premiums are lower than those of standard options. The barrier limits the probability that the option will expire in the money. Buyers accept the risk of early cancellation in exchange for a reduced initial cost. Option sellers issue these contracts to strictly cap their maximum potential loss.
Example
Suppose Elephants are trading international agricultural commodities and want to secure a position in peanut futures. The current market price of peanuts is $1,000 per metric ton. Elephants anticipate a moderate price increase over the next three months. They purchase an up-and-out call option with a strike price of $1,100 and a knock-out barrier of $1,400.
If the price of peanuts rises to $1,200 and remains there until expiration, Elephants exercise the option to buy at $1,100 and secure a profit. If sudden supply constraints cause the price of peanuts to spike to $1,400 during the second month, the option is knocked out. The contract is immediately canceled. Elephants lose the initial premium paid for the option, and they receive no payout even if the price of peanuts falls back to $1,200 before the expiration date.