What is a ‘Knock-In Option’
A knock-in option is a latent option contract that becomes active as a conventional option contract only when a specified price level is achieved before the option contract’s expiration date. Known as knock-in options, they are a form of barrier option that may be either a down-and-in option or an up-and-in option depending on the situation.
In financial markets, an option on a barrier security is a form of contract in which the payout is contingent on the underlying asset’s price and whether it reaches a particular price within a given time period.
Explaining ‘Knock-In Option’
Knock-in and knock-out choices are the two most common sorts of barrier alternatives to choose from. A knock-in option is a sort of contract that does not become an option until a specific price is met; hence, if the price is not met, the contract is treated as if it never existed in the first place.
The knock-in option, on the other hand, is activated when the underlying asset exceeds a certain threshold. There is a distinction between a knock-in option and a knock-out option in that a knock-in option comes into being only when the underlying security reaches an impassable barrier, but a knock-out option ceases to exist when an impassable barrier is reached.
Consider the following scenario: an investor acquires a down-and-in put option contract with a barrier price of $90 and a strike price of $100 while the underlying securities was trading at $110 and there are three months left until the contract expires. As soon as the price of the underlying asset reaches $90, the option becomes valid and becomes a vanilla option with a strike price of $100, therefore bringing the option into life.
Following that, the option holder will have the opportunity to sell the underlying asset at the strike price of $100, if the option is exercised. Even if the underlying asset recovers from its low point of $90, the put option remains in effect until the expiration date. Down-and-in options are worthless, however, if the underlying asset does not fall below a predetermined barrier price at any time during the contract’s duration.
Up-and-in options, unlike down-and-in options, are only activated if the barrier is met, which must be greater than the underlying asset’s price in order for the option to be valid. Consider the following scenario: a trader purchases a one-month up-and-in call option on an underlying asset while the asset was trading at $40 per share at the time of acquisition.
The striking price of the up-and-in call option contract is $50, with a barrier of $55 as the contract’s barrier. Option contracts expire worthless if the value of the underlying asset does not exceed $55 at any point during the term of the contract. Call options would become available, however, if the value of the underlying asset climbed to $55 or higher.
Knock In Option FAQ
How do knockout options work?
A knock-out option is an option that has a built-in mechanism that will cause it to expire worthless if a specific price level in the underlying asset is achieved before the option has expired. The lower profit potential for the option buyer means that knock-out options can be acquired for a lower premium than a comparable option that does not include a knock-out restriction.
What is reverse knock in?
A reverse knock-out option is a knock-out option in which the barrier is in-the-money with regard to the strike when the option is knocked out. A reverse knock-in option is a knock-in option in which the barrier is in-the-money with regard to the strike price when the option is exercised.
What is a double knock in option?
It is possible to trade a double barrier option that has two obstacles in relation to the strike price: an upper barrier and a lower barrier. A level at which the trigger price is above the strike price is defined by the higher barrier, and a level at which the trigger price is below the strike price is defined by the lower barrier.
What is European knock in?
A European knock-in (eki) is a vanilla alternative with a European barrier built in to make it more appealing. That is, only the location of the underlying asset in relation to the barrier on the expiration date of the option is important. If there is a dividend, it will be the same as the payoff for the underlying vanilla option (if any).
What is knock in knock out option?
Only when a certain price specified for the asset is satisfied is a knock-in option recognized, but knock-out options are no longer recognized if the specific price set for the asset is fulfilled.
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- Pricing and hedging of American knock-in options – jod.pm-research.com [PDF]
- Static hedging and pricing American knock-in put options – www.sciencedirect.com [PDF]
- One-touch double barrier binary option values – www.tandfonline.com [PDF]
- Monte-Carlo importance sampling simulation method for pricing the European knock-in option – en.cnki.com.cn [PDF]
- Risk Management Lessons from ‘Knock‐in Knock‐out’ Option Disaster – onlinelibrary.wiley.com [PDF]
- Pricing double barrier options using Laplace transforms – link.springer.com [PDF]
- Pricing Parisan Options – jod.pm-research.com [PDF]