Knock-Out

Definition

A Knock-Out is a vanilla option that ceases to exist (is "knocked-out") if the underlying spot breaches a predetermined barrier before maturity.

Barrier

For a regular Knock-Out, the barrier is OTM, i.e., below the strike for a call and above the strike for a Put. For a reverse Knock-Out (or "kick-out"), the barrier is ITM, i.e., above the strike for a call and below the strike for a Put.

Premium

The Knock-Out premium is lower than that of a regular Vanilla option. The closer the barrier from spot, the lower the premium, as there is higher probability that the option will be knocked out before expiry.

Payoff

If the barrier is not knocked-out, then the profile of a Knock-Out option is the same as a regular Vanilla option. If the option is knocked-out, the customer is no longer hedged against adverse market movements.