What Are Up-and-Out Options?
An up-and-out option is a type of knock-out barrier option that ceases to exist once the price of the underlying asset rises above a predetermined barrier level. Unlike standard options, these options become worthless if the underlying reaches the barrier price at any point during the option’s life. If the barrier is not breached, the option behaves like a regular call or put option, allowing the holder to exercise their right at the strike price before expiry.
Key Highlights
- An up-and-out option is terminated if the underlying asset’s price surpasses a specified barrier.
- A down-and-out option, conversely, is nullified if the underlying asset’s price dips below a set barrier.
- Up-and-out options are generally more economical than vanilla options due to the knockout clause adding the risk of expiration.
Dive Deeper Into Up-and-Out Options
An up-and-out option is categorized as an exotic option and forms one of two major knock-out barrier options, the other being the down-and-out option. These can come in either call or put forms. A barrier option’s value and existence hinge on the underlying asset hitting a certain price.
If the underlying asset hits the barrier price anytime during the life of an up-and-out option, it is nullified, irrespective of any price drop back below the barrier later. For example, consider an up-and-out call option with a $80 strike price and a $100 knock-out barrier. If the stock rises from $75 to hit $100 before the option can be exercised, the option becomes worthless.
Knock-in barrier options work oppositely, gaining value once the barrier is breached. Additionally, comparison can be made with down-and-out options, which expire worthless if the underlying price drops below a barrier.
Real-Life Application: Using Up-and-Out Options
Institutional investors or market makers customize these options per clients’ agreements and requirements. For instance, a portfolio manager might use an up-and-out option as a budget-friendly hedge against potential losses on a short position. Though cost-effective, this hedge would be limited as it offers no protection beyond the barrier price.
Pricing involves all standard option metrics plus the added complexity of the knockout clause. Limited liquidity is typical for such contracts as they are traded over-the-counter, often requiring buyers to accept premiums set by sellers for lack of competitive options. Up-and-out options usually carry lower premiums than equivalent vanilla options due to the added knockout risk.
Example: Institutional Use of Up-and-Out Options
Let’s say an institutional investor anticipates a rise in Apple Inc. (AAPL)’s stock price. They aim to purchase 100 call contracts price-efficiently and consider using up-and-out options, which are generally cheaper than vanilla calls.
If Apple’s stock is currently at $200, and the investor predicts the price won’t surpass $240 within three months, they might buy an up-and-out option with a $200 strike price and a $240 knockout barrier. Given that a vanilla option with these parameters costs $11.80 per contract (totaling $118,000 for 100 contracts), the firm receives a quote for $8.80 per up-and-out option, saving $30,000 in premium costs.
The investor’s breakeven is $208.80 ($200 + $8.80). They profit if Apple’s stock trades between $208.80 and $240 within three months. However, if Apple touches $240 before expiration, the options become void, arriving at an $88,000 loss in premiums.
Understanding these facets of up-and-out options enables investors to make informed decisions to employ financially savvy hedges and strategic trades.
Related Terms: knock-out option, vanilla option, call option, put option, barrier price.
References
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
- Nasdaq. “Down-and-out Option”.
