What Is a Knock-In Option?
Let me explain what a knock-in option is. It's essentially a latent option contract that only starts functioning like a normal option— what we call 'knocking in'— once a certain price level is reached before it expires. You should know that knock-ins fall under barrier options, specifically classified as down-and-in or up-and-in. A barrier option is a contract where the payoff hinges on whether the underlying security's price hits a specific level within a set time frame.
Key Takeaways on Knock-In Options
Here's what you need to grasp about knock-in options: they become active only when the underlying asset hits a specific barrier, which makes them a distinctive type of barrier option. You'll find two main types— down-and-in options that activate if prices drop below a set level, and up-and-in options that kick in if prices climb above a certain point. I want to point out that knock-in options often come with lower premiums than traditional vanilla options because of that extra barrier condition, which raises the odds of the option expiring worthless. And if the underlying asset's price never reaches that barrier during the option's lifespan, the knock-in option simply has no effect and expires as though it never existed.
How Do Knock-In Options Work?
Knock-in options are one of the two primary types of barrier options, the other being knock-out options. Think of a knock-in option as a contract that isn't really an option until a specific price is met. If that price is never reached, the contract basically doesn't exist. But if the underlying asset does hit the specified barrier, the knock-in option springs into existence. To clarify, a knock-in activates when the security hits the barrier, whereas a knock-out ends upon hitting it.
Barrier options like these usually have cheaper premiums than standard vanilla options, mainly because the barrier boosts the chances of the option expiring worthless. As a trader, you might choose these cheaper barrier options over vanilla ones if you believe the underlying will indeed hit the barrier.
Exploring Down-and-In Knock-In Options
Let's dive into down-and-in knock-in options with an example. Suppose you, as an investor, buy a down-and-in put option with a barrier price of $90 and a strike price of $100. The underlying security is currently trading at $110, and the option expires in three months. If the price drops to $90, the option activates and turns into a vanilla option with that $100 strike. From there, you have the right to sell the underlying asset at $100, even if it's trading below $90— that's what gives it value.
Once activated, the put option remains active until expiration, even if the security bounces back above $90. However, if the underlying never falls below the barrier during the contract's life, the down-and-in option expires worthless. Remember, hitting the barrier doesn't guarantee a profit; the underlying needs to stay below $100 for the option to hold value.
Understanding Up-and-In Knock-In Options
On the flip side, an up-and-in option only comes into existence if the underlying reaches a barrier price that's above the current price. For instance, imagine you purchase a one-month up-and-in call option on an asset trading at $40 per share. This contract has a strike price of $50 and a barrier of $55. If the asset doesn't hit $55 during the option's life, it expires worthless. But if it rises to $55 or higher, the call option activates, and you'll be in the money as the trader.
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