27 May, 2022

I build businesses, both as independent startups and as new initiatives within large global companies. This series of posts is based on an FX Options training course that I delivered whilst contributing to building FX businesses at a number of investment banks. If you are looking to build a business and require leadership then please contact me via the About section of this website.

FX Options Guide - Section 11 - Knockout Option

Knockout Option Introduction

In this section we start to look at barrier options. To get the most from this section you should first have covered the foundational FX options knowledge including the terminology of FX options and looked at some common option strategies. You should also have covered how options are funded and how these funding techniques are used when combining options.

Knockout Option

The knockout option was one of the first exotic options to become popular in the foreign exchange market. As early as the late 1980’s it was used by Japanese traders who tended to sell knockouts in trending markets. Knockouts are perhaps the most intuitive of the barrier family due to their similarity to standard European options.

Features

The knockout option differs from a standard option by the additional feature of an outstrike price. The outstrike price is a predefined rate such that if spot trades at or beyond the outstrike price during global trading hours from the time at which a trade is executed, until the expiration time on the expiration date of the option, then the option terminates. If the outstrike is never triggered then the pay-off from the knockout option at expiration is identical to that of the equivalent standard European option.

The cost of a knockout option is less than the cost of the equivalent standard option.

The feature that distinguishes a knockout option from other barrier options is the location of the outstrike relative to both spot and the options strike price. The outstrike price of a knockout option is set such that spot needs to move in the direction of Out-Of-The-Money with respect to the option for the outstrike to be triggered. That is, the option is falling in value when the outstrike price is triggered.

Types of Knockout Option

There are three types of knockout option:

• Regular Knockout
• Strikeout
• Parityout

Regular Knockout Option

The regular knockout option is by far the most common type of knockout option. It is characterised by the fact that the outstrike is chosen such that it is out-of-the-money with respect to the strike price.

Strikeout Option

The strikeout option is a special case of a knockout option where the outstrike is chosen such that it is the same as the strike price.

Parityout Option

The parityout is the most extreme of the knockout options. The parityout differs from other types of knockout in that the outstrike is chosen such that it is In-The-Money with respect to the strike price. Note that both the strike and outstrike are out-of-the-money with respect to spot.

Knockout Option – How It Is Used

As the knockout option is so similar to a standard European option it can be used in place of a standard option in any strategy. However, the knockout option is used frequently in specific strategies.

Hedging Strategies

1. Buy a knockout option

The knockout option is ideally suited to hedging transactional exposures, and offers a lower cost alternative to a standard option. Adverse movements in the underlying are hedged by the knockout as they would be by a standard option providing that the outstrike is not triggered. For the outstrike to have been triggered spot would have to have moved favourably with respect to the underlying exposure, which would have appreciated in value. However, if the outstrike is triggered the exposure becomes unhedged, therefore, it is essential that the gains in the underlying are locked-in in some way. This could be achieved by placing an order at outstrike to replace the knockout option with either a forward or an option.

1. Buy a knockout option spread

As an alternative to simply buying a knockout option, a call spread or a put spread can be bought where both the long and the short leg of the strategy have the same outstrike price. This strategy is cheaper alternative to simply buying a knockout option. It is particularly well suited to exposures of six months or greater. The strategy requires active management.

1. Risk Reversal with the long leg a knockout
2. Buy a knockout versus selling a strangle

Trading Strategies

1. Buy a knockout option

Knockout options can be used to incorporate a technical analysis view into an options strategy. A knockout option is bought where the outstrike is placed just beyond a technical support or resistance level that is expected to hold, therefore effectively protecting the outstrike from being triggered. As the knockout trades at a discount to the equivalent standard European option it provides a lower cost alternative, therefore increasing the leverage that the trader can achieve.

1. Sell a knockout option

The seller of a knockout option receives a premium. If the knockout option is knocked out then the seller keeps the premium, but no longer has a liability from the short option. Therefore, traders sell knockout options with outstrikes that they believe will be triggered. This is a particularly effective strategy in trending markets.

Next Section - Knockout Option Pricing

In the next section we continue our introduction to barrier options by looking at knockout option pricing.

About The Author

I build businesses, both as independent startups and as new initiatives within large global companies. If you want to know more then visit the About section of this website.