Alive until a level's crossed:then knocked out, and the option's lost.
A type of barrier option that ceases to exist if the underlying price reaches a specified level, the barrier, during the option’s life.
In the standard form the option stays cancelled whatever the price does afterwards; some contracts pay a rebate when this happens.
In plain words
A knock-out option is an option, a contract giving the right to buy or sell at a set price called the strike, that is cancelled if the underlying price touches a chosen level called the barrier. Once it has been knocked out it stays cancelled, whatever the price does afterwards.
See it move
Underlying price has crossed Barrier: Option ends
Why it matters
The possibility of cancellation makes a knock-out option cheaper than an ordinary option with the same terms. The holder accepts that a touch of the barrier ends the contract even if the price later moves the way they had hoped.
Worked example
An example only. The figures are round and invented for the arithmetic: they are not market prices.
A buyer pays a premium of 100 for a knock-out call, the right to buy, with a strike of 1.2000 and a barrier below it at 1.1800.
- 1The price dips to 1.1800the barrier is touched and the option is cancelled
- 2The price then recovers and finishes at 1.2300
- 3An ordinary call with the same strike would finish 1.2300 − 1.2000 = 0.0300, or 300 pips, above its strike
The knock-out holder has nothing at expiry and has lost the premium of 100, because the cancellation happened on the way.
A common mistake
It is natural to think that only the price at expiry matters. For a barrier option the path matters: in the standard form, one touch of the barrier during the option’s life is enough.
Check yourself
Educational information, not investment advice or a recommendation to trade.