# Knock-Out Options: What They Are, Types, Benefits & Drawbacks

## What Is a Knock-Out Option?

A knock-out option is a barrier option with a built-in mechanism causing it to expire worthless if the underlying asset hits a specified price level. This design introduces limits on potential gains, allowing these options to be acquired at lower premiums than standard options. Primarily utilized by large institutions in commodity and currency markets, knock-out options may also be traded over-the-counter. Understanding both "down-and-out" and "up-and-out" types helps investors manage risk with specific strategies.

### Key Takeaways

*   Knock-out options are a type of barrier option that expire worthless if the underlying asset hits a specified price.
*   There are two types of knock-out options: down-and-out and up-and-out, each defined by different price barriers.
*   Investors can purchase knock-out options for lower premiums, but they limit potential profits if the barrier price is breached.
*   These options are primarily used in commodity and currency markets and offer strategic benefits for specific hedging needs.
*   Knock-out options are considered exotic options and may be less accessible to individual investors.

## In-Depth Look at Knock-Out Options

A knock-out option is a type of [barrier option](https://www.investopedia.com/terms/b/barrieroption.asp). Barrier options are usually divided into knock-out or knock-in types. A knock-out option expires if the asset hits a predetermined barrier during its term. A knock-in option is effectively the opposite of a knock-out option. Here, the option is activated only if the underlying asset reaches a predetermined barrier price.

Knock-out options are exotic and mainly used by large institutions in commodity and currency markets. They may also be traded [over-the-counter](https://www.investopedia.com/terms/o/otc.asp) (OTC).

## Exploring the Two Types of Knock-Out Options

Knock-out options come in two basic types:

### Down-and-Out Option

A [down-and-out option](https://www.investopedia.com/terms/d/daoo.asp) is one variety. It gives the holder the right, but not the obligation, to purchase or sell an underlying asset at a predetermined strike price—if the underlying asset's price does not go _below_ a specified barrier during the option's life. Should the underlying asset's price fall below the barrier at any point in the option's life, the option expires worthless.

For example, assume an investor purchases a down-and-out [call option](https://www.investopedia.com/terms/c/calloption.asp) on a stock that is trading at $60, with a [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) of $55 and a barrier of $50. If the stock trades below $50, at any time, before the call option expires then the down-and-out call option promptly ceases to exist. 

### Up-and-Out Option

Contrary to a down-and-out barrier option, an [up-and-out barrier option](https://www.investopedia.com/terms/u/up-and-outoption.asp) gives the holder the right to buy or sell an underlying asset at a specified strike price if the asset has not _exceeded_ a specified barrier during the option's life. An up-and-out option is only knocked out if the price of the underlying asset moves above the barrier.

Assume an investor purchases an up-and-out [put option](https://www.investopedia.com/terms/p/putoption.asp) on a stock trading at $40, with a strike price of $30 and a barrier of $45. Over the life of the option, the stock hits a high of $46 but then drops to $20 per share. Too bad: the option still would automatically expire because the barrier of $45 had been breached. Now, if the stock hadn't gone above $45 and eventually sold off to $20, then the option would remain in place and have value to the holder.

## Pros and Cons of Knock-Out Options

A knock-out option may be used for several different reasons. As mentioned, the [premiums on these options](https://www.investopedia.com/articles/active-trading/041414/use-knockout-options-lower-cost-hedging.asp) are typically cheaper than a non-knock-out counterpart. A trader may also feel that the odds of the underlying asset hitting the barrier price are remote and conclude that the cheaper option is worth the risk of unlikely being knocked out of the trade. 

These options help institutions hedge to specific prices or manage narrow risk tolerances.

Pros

*   Have lower premiums
    
*   Limit losses
    
*   Good for specific hedge/risk-management strategies
    

Cons

*   Vulnerable in volatile markets
    
*   Limit profits
    
*   Exotic options often less accessible to investors
    

Knock-out options limit losses but also cap profits on the upside. Moreover, the knock-out feature is triggered even if the designated level is breached only briefly. That can prove dangerous in volatile markets.

## Knock-Out Option Example Explained

Let's say an investor is interested in Company ABC, with a share price of $17 as of March 20. By May 2, it closed at $22.92 per share. Say our investor is bullish on the company but still cautious.

The investor may write a call option at $23 per share with a strike price of $33 and a knock-out level of $43. This option only allows the option holder (buyer) to profit as the underlying stock moves up to $43, at which point the option expires worthless, thus limiting the loss potential for the option writer (seller).

## What Is a Knock-Out vs. a Knock-in Option?

A knock-out option expires worthless if a certain price of an asset is reached. A knock-in option is the opposite. It is an option that becomes a regular option once a set price is achieved. If this price is not reached, it is almost as if the option never existed as it does not come into play.

## What Is an Example of a Knock-in Option?

An example of a knock-in option would be buying one to purchase a company's share for a strike price of $40 with a knock-in price of $50. If the price of the stock does not hit $50, then no option exists. If the price hits $50 then the option is "activated," which creates a regular option with a $40 strike price.  

## Can Anyone Trade Options?

Yes, anyone can trade options. You do not have to work for a financial institution or other company to do this. All you need is to open your own brokerage account. However, it is not that simple. Because options are more complex than trading regular stocks and bonds, your broker will need to approve you to trade options based on multiple factors, such as your trading experience, your financial profile, and your investment goals. If you'd like to trade options, start by speaking to your brokerage to find out what is involved.

## The Bottom Line

Knock-out options, which expire worthless when a specified price level is breached, offer the benefit of lower premiums compared to traditional options. However, they also cap potential profits. Investors may find knock-out options appealing if they believe the likelihood of hitting the barrier is low, making them a cost-effective way to hedge positions or speculate on market movements. Yet, it's crucial to consider the risk of these options being nullified in volatile markets, limiting potential gains.