A knock-in option is a unique options contract that activates only once a specific price barrier is reached before its expiration date. Knock-in options belong to a broader category of barrier options and are subdivided into two types: down-and-in and up-and-in. Barrier options distinguish themselves from conventional options by making the payoff dependent on the underlying asset hit a predetermined price within a specified time frame.
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Key Takeaways
- Knock-in options are types of barrier options that activate only when the underlying asset’s price reaches a specified barrier.
- Two primary variations exist for knock-in options: down-and-in and up-and-in. Down-and-in options activate when the asset’s price falls below a certain level, while up-and-in options trigger if the price surpasses a specific higher level.
Understanding Knock-In Options: The Fundamentals
Knock-in options, as part of the barrier options family, stand as fundamental financial tools. Unlike traditional options, a knock-in option isn’t a viable financial instrument until a stipulated price is achieved. In that way, if the barrier price is never met, the deal practically never occurred. Nevertheless, once that price threshold is crossed, the knock-in option immediately becomes an active option.
As you’re weighing your financial instruments, particularly against knock-out options, recall that knock-in options engage when a barrier is reached, whereas knock-out options disengage upon hitting a specific barrier.
Barrier options are generally available at lower premiums than classic vanilla options. Despite these lower costs, the presence of a barrier diminishes the likelihood of the option yielding success, imparting it a unique risk dynamic. Traders often opt for barrier options if they believe it’s likely that the underlying asset will breach the designated price points.
Down-and-In Knock-In Option: A Comprehensive Example
Imagine an investor who buys a down-and-in put option carrying a barrier price of $90 and a strike price of $100. Initially, the underlying asset trades at $110, with the option set to expire in three months. If the asset’s price dips to $90, this triggers the knock-in condition, thus the option solidifies into a traditional option now possessing a strike price of $100. Consequently, the investor gains the right to sell the asset at $100, though it may trade below $90 in actuality—producing intrinsic value for the right.
This specific put option remains in effect until expiry, regardless of a price rebound above $90. If the barrier isn’t surpassed within the contract span, the down-and-in option null commands zero value—a loss to the investor. Simply crossing the barrier does not guarantee trading profits; the underlining stock must stay below $100 post barrier-trigger to maintain option value.
Up-and-In Knock-In Option: Realizing Potential Upper Price Barriers
On the contrary, up-and-in options offer a different take. This option type springs to life only when the asset climbs above a designated barrier higher than the existing asset price. For example, consider a trader who buys a one-month up-and-in call option on an asset trading at $40 per share. With stipulated conditions: a $50 strike price and a barrier of $55. Should the underlying asset fail to touch $55 during the life cycle of the option contract, it expires worthless. However, if the asset pierces $55, the call option activates, positioning the trader comfortably in the money.
Related Terms: Barrier Options, Knock-Out Options, Vanilla Options, Put Options, Call Options.
