A put option becomes worthless if the price of the underlying security falls below a predetermined level, making it a type of barrier option. This option is cheaper than vanilla options, which can become extremely profitable. Knockout options have a second price level that makes them worthless, while knock-in options allow the buyer to exercise regardless of the underlying security price.
A put option is a type of option that has no value if the price of the option’s underlying security rises or falls below a predetermined price level. If that happens, the option is removed and it no longer matters what the price of the underlying security does. The opt-out is a particular type of barrier option, which usually has a small discount for investors compared to so-called vanilla options. This is because this type of option becomes worthless at a time when other options become extremely profitable.
Options are investment vehicles that allow investors to speculate on the price of an underlying security without obtaining physical ownership of that security, although they may eventually own the security in the transaction. Option buyers pay a price known as the premium for the option, which can be exercised if the price reaches a predetermined strike price, a state also known as being in the money. If the underlying security does not pay in before the option expires, the contract is worthless. With a knockout option, a second price level comes into play that makes the option worthless, even if it is in the money.
As an example of how a knockout option works, imagine that a buyer buys an option to buy, also known as a call option, a security that is currently priced at $90 United States Dollars (USD) if it reaches a strike price of $100 USD. The option seller, or writer, adds a $120 USD exclusion barrier. That means that even if the price exceeds the strike price of $100 USD, the option will be worthless once the price reaches $120 USD.
This example illustrates the dangers of buying an opt-out. If it were a vanilla option with no barrier, the option would become extremely profitable for the buyer if it broke through the $120 USD barrier and beyond. Such an example shows the reason why barrier options are cheap compared to vanilla options, as the security underlying a barrier option has to be set in a price window, not too high and not too low, so that works for the buyer.
The opposite of the knockout option is the knockout option, which allows the buyer to exercise no matter what the underlying security price does after reaching that barrier. Knockout options are one way an option writer can protect against big losses. By setting the barrier at a reasonable amount, you prevent the option from going too far in the money.
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