Knock out level

What Is a Knock Out Level?

A knock out level, also known as a barrier, is a predetermined price point for an underlying asset that, if reached or breached, automatically terminates a derivative contract, rendering it worthless. This condition is a defining characteristic of certain derivative instruments, primarily barrier options and some structured product offerings. When the underlying asset's price hits the knock out level, the option ceases to exist, meaning any potential payoff that might have occurred if the price subsequently moved favorably is forgone. The inclusion of a knock out level typically reduces the initial premium of the option compared to a standard option without such a barrier, reflecting the reduced probability of the option reaching its expiration date with value.

History and Origin

The concept of options and derivatives has roots extending centuries, with informal over-the-counter options traded as early as the late 1700s in the United States. However, these were often bilateral and lacked standardization. The modern era of listed, standardized options began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked a significant shift, bringing options trading to a wider audience with standardized terms and a central clearing entity.⁶

As the derivatives market evolved, financial engineers sought to create more complex instruments that offered tailored risk-reward profiles. Barrier options, including those with a knock out level, emerged as a response to this demand. These options provided investors and institutions with more precise tools for hedging specific price movements and managing exposure, effectively allowing for customized bets on how an asset's price might behave within certain boundaries, rather than just its direction.

Key Takeaways

• A knock out level is a price barrier in a derivative contract, such as a barrier option or structured product.
• If the underlying asset's price touches or crosses this level, the derivative contract immediately terminates.
• Options with a knock out level generally have a lower initial premium than comparable standard options because of the added risk of early termination.
• They are used by investors seeking to customize their exposure to price movements and manage potential costs.
• Knock out levels are a core feature of path-dependent derivatives.

Formula and Calculation

A knock out level itself is a specific price point, not a formula. However, its presence significantly impacts the pricing model of the derivative, often a barrier option. The value of an option with a knock out barrier is typically determined using complex mathematical models that account for the probability of the underlying asset's price hitting the barrier before the option expires. These models, such as variations of the Black-Scholes model for barrier options, incorporate factors like the underlying asset's current price, the strike price, time to expiration, volatility, and interest rates.

For a knock-out call option (e.g., an up-and-out call, where the barrier is above the current price):
The option's value becomes zero if the asset price (S_t) at any time (t) reaches or exceeds the barrier (B).
For a knock-out put option (e.g., a down-and-out put, where the barrier is below the current price):
The option's value becomes zero if the asset price (S_t) at any time (t) falls to or below the barrier (B).

The pricing of such options involves integrating over possible price paths, considering the likelihood of the barrier being hit.

Interpreting the Knock Out Level

Interpreting a knock out level involves understanding its role in defining the risk and reward profile of a derivative. For an investor, a knock out level represents a point of maximum tolerable adverse price movement for the option to remain active. If a call option has an up-and-out barrier, the investor believes the price will rise but not exceed a certain level. If it's a down-and-out put option, the investor expects the price to fall but not below a specific threshold.

The primary implication of a knock out level is that it caps potential profits or limits the duration of the trade under certain conditions. While it makes the option cheaper to acquire, it also introduces the risk of early termination, which can lead to a complete loss of the premium paid, even if the underlying asset eventually moves in the desired direction after the knock out event. Therefore, investors use knock out levels to express nuanced views on market direction and range, rather than simply directional bets. These instruments are a component of sophisticated risk management strategies.

Hypothetical Example

Consider an investor who believes that Company XYZ's stock, currently trading at $100, will rise but will likely not exceed $120 in the near term. To profit from this view while limiting the cost, they purchase a 3-month "up-and-out" call option on Company XYZ with a strike price of $105 and a knock out level of $120. The premium for this option is $3.00 per share.

• Scenario 1: Stock price rises to $115 and stays below $120. The option remains active. If, at expiration, the stock is at $115, the investor exercises the option, buying shares at $105 and selling them at $115, realizing a gross profit of $10 per share. After deducting the $3.00 premium, the net profit is $7.00 per share.
• Scenario 2: Stock price rises to $125. As soon as the stock price touches or exceeds $120 (the knock out level), the option instantly terminates. Even if the stock then drops back to $110 or surges to $150, the option is worthless. The investor loses the entire $3.00 premium paid for the option.

This example illustrates how a knock out level offers a lower initial cost but introduces the risk of the contract becoming worthless if the barrier is hit, regardless of subsequent price action.

Practical Applications

Knock out levels are commonly found in barrier options, which are traded in over-the-counter (OTC) markets and are also embedded within various structured product offerings. These financial instruments are designed to provide customized exposure to an underlying asset with specific conditions that modify their payoff profiles.

In the realm of structured products, a knock out level might be used in notes that offer enhanced returns as long as the underlying index or equity stays within a predefined range. For example, a structured note might offer a high coupon payment if a stock index remains above a certain "down-and-out" barrier.⁵ Issuers, typically financial institutions, utilize knock out levels to tailor products that appeal to investors with particular market outlooks, often aiming for principal protection or enhanced yield within certain market conditions.⁴ These products are typically debt obligations combined with a derivative component.

Corporations and institutional investors also use knock out levels in bespoke derivative contracts for specific hedging purposes in capital markets, allowing them to fine-tune their exposure to currency fluctuations, commodity prices, or interest rate movements while reducing the cost of the hedge if certain price limits are not breached. The U.S. Securities and Exchange Commission (SEC) provides general information about options and their terminology, including how they function as contracts to buy or sell securities at a fixed price within a specific period.³

Limitations and Criticisms

While knock out levels can reduce the initial cost of a derivative and allow for highly customized strategies, they come with significant limitations and criticisms. The most notable drawback is the risk of complete loss of the premium paid if the knock out level is breached, even if the underlying asset subsequently moves back in a favorable direction. This "path dependency" means that the derivative's value is not solely determined by its price at expiration date, but by its journey throughout the contract's life.

For investors, especially less sophisticated ones, the complexity of products containing knock out levels can be a challenge. These instruments can be opaque, and their embedded conditions might not be fully understood, leading to unexpected losses. Financial regulators, including the Federal Reserve, have highlighted the complexities and potential for significant losses associated with derivatives, particularly over-the-counter contracts, due to factors like counterparty risk, model risk, and settlement risk.² The illiquid nature of many tailored derivatives, including certain structured products, can further exacerbate losses, as investors may not be able to sell their positions easily before maturity.¹

Critics argue that such complex structures can lead to mispricing or unsuitable recommendations, particularly when sold to retail investors who may not fully grasp the implications of the knock out feature on their potential returns and capital at risk.

Knock Out Level vs. Knock-in Level

The terms "knock out level" and "knock-in level" both refer to price barriers within derivative contracts, typically barrier options, but they define opposite conditions for the option's activation or termination.

A knock out level is a barrier that, if touched or breached by the underlying asset's price, causes the option to terminate and become worthless. The option is active from the moment it is purchased until the barrier is hit or the expiration date is reached. This type of option is often used when an investor expects a price movement but wants to limit the cost, accepting the risk of early termination if the market moves too far against or beyond their specific outlook.

Conversely, a knock-in level is a barrier that, if touched or breached by the underlying asset's price, causes the option to activate or "come into existence." If the knock-in barrier is not reached, the option never becomes active and expires worthless. Investors typically use knock-in options when they expect a specific price threshold to be crossed before the option becomes relevant, allowing them to pay a lower premium compared to a standard option.

The key distinction lies in causality: a knock out level ends the option, while a knock-in level begins the option.

FAQs

What type of investments use a knock out level?

Knock out levels are primarily used in specific types of derivative contracts, most notably barrier options, such as "up-and-out" calls or "down-and-out" puts. They are also frequently embedded in complex structured products issued by financial institutions, where the payoff is linked to the performance of an underlying asset within certain predefined price boundaries.

Why would an investor choose an option with a knock out level?

Investors might choose an option with a knock out level primarily because it typically comes with a lower premium compared to a standard option without such a barrier. This reduced cost is due to the increased risk of the option terminating early. It allows investors to express a more nuanced market view—for example, expecting an asset's price to move in a certain direction but within a specific range, thereby limiting the upfront investment.

Can I lose my entire investment with a knock out level?

Yes, if the underlying asset's price touches or breaches the knock out level, the derivative contract (e.g., the option) immediately terminates and becomes worthless. In such a scenario, the investor loses the entire premium paid for the option, even if the underlying asset's price subsequently moves back in a direction that would have been profitable for a standard option. This is a significant risk associated with these instruments.