Key product features
• Participate in a favourable move in the underlying exchange rate as long as a predetermined spot rate – called the “barrier” level – has not been reached or breached.
• Barrier level can be ITM or OTM.
• Upfront premium.
Product description/scenario
• A Knock-Out Call or Put is a modification to the Vanilla that ceases to exist if the spot trades at or beyond a pre-specified barrier level.
• This option is cheaper than an equivalent Vanilla, because there is a possibility that the option will cease to exist.
• A Knock-Out with a barrier that is In-The-Money is called a Reverse Knock-Out, shown in the trade profile below.
• A Knock-Out with a barrier that is Out-The-Money is called a Normal or Regular Knock-Out.
Example trade profile
Payout profile at expiry
Payoff description
• If spot has never reached or breached the knock- out level (1.4500) and at expiry is:
– Above the strike (1.3500), you buy EUR 1mio, sells USD 1.35mio.
– Below strike (1.3500), you are free to trade at the prevailing market spot rate.
• If spot has reached or breached the knock-out level (1.4500) at any point in time, the option ceases to exist, no payout is made.
Variations
• European style:
– The barrier is live only at expiry.
• Discrete style:
– The barrier is live for predetermined discrete points in time during the life of the option.
Knock-Out Option
Linear Mode
