What Is an Up-and-Out Option?
Let me explain what an up-and-out option is. It's a type of knock-out barrier option that simply stops existing if the price of the underlying security goes above a specific level, which we call the barrier price.
If the underlying price never hits that barrier, the option behaves just like a regular one. You, as the holder, have the right but not the obligation to exercise your call or put at the strike price on or before the expiration date in the contract.
Key Takeaways
Here's what you need to know: An up-and-out option is an options contract that ends if the underlying asset moves above the barrier price. There's also a down-and-out version that knocks out if the price drops below the barrier. These are usually cheaper than plain vanilla options because of the knockout risk, which can make the option worthless.
Understanding Up-and-Out Options
You should consider up-and-out options as exotic options. They're one of two knock-out barrier types—the other being down-and-out. Both come as puts or calls. A barrier option's payoff and existence depend on whether the underlying asset hits a set price.
With a knock-out, it expires worthless if the underlying reaches the barrier, capping profits for you as the holder and losses for the writer. The key point is that once it hits the barrier during the option's life, it's gone for good, even if the price moves back.
For instance, take an up-and-out with a $80 strike and $100 knock-out. If the stock starts at $75 but hits $100 before you can exercise, the option expires worthless, no matter what happens later.
Barrier options can also be knock-ins, which only gain value after hitting the barrier. Compare that to down-and-outs, where the option vanishes if the price falls below the barrier.
Tip on Up-and-Out Options
Remember, an up-and-out can be a call or a put. Either way, it gets knocked out if the underlying rises above the barrier price.
Using Up-and-Out Options
Large institutions or market makers create these through direct deals with clients who need them. For example, if you're a portfolio manager, you might use them to hedge losses on a short position more cheaply than with vanilla calls. It's not a perfect hedge, though, since you're exposed if the price goes over the barrier.
Pricing factors in all the usual option metrics, plus the knock-out feature. These trade over-the-counter with limited liquidity, so you take the quoted premium or negotiate. Vanilla premiums give a starting point—expect an up-and-out call to cost less than a matching vanilla call.
Example of an Up-and-Out Option
Let's look at a practical example. Suppose an institutional investor wants calls on Apple Inc. (AAPL) because they think the price will rise. They need 100 contracts and want to minimize costs, so they consider up-and-out options, which are cheaper than vanilla ones.
Apple is at $200, and they believe it'll go above $200 in three months but not past $240. They buy an at-the-money up-and-out with $200 strike, three-month expiration, and $240 knock-out.
A vanilla three-month $200 strike costs $11.80 per contract ($1,180 total per), so 100 contracts run $118,000. But they get a quote for the up-and-out at $8.80, totaling $88,000—saving $30,000.
Their breakeven is $200 plus $8.80, or $208.80. They profit if Apple goes above $208.80 but stays under $240. If it touches $240 anytime before expiration, the options vanish, and they lose the $88,000 premium.
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