5 August, 2022

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FX Options Guide - Section 16 - Reverse Knockin Option

Reverse Knockin Option Introduction

In this section we further our look at barrier options by looking at reverse knockin options. To get the most from this section you should first have covered the section on reverse knockout options and the earlier sections on knockout options, the knockout option pricing examples and the knockout option risk management considerations.

Reverse Knockin Option

The reverse knockin option is widely used in both hedging and trading strategies. The reverse knockin is often sold to fund the purchase of another option, as an alternative to selling a standard European option.

Features

The reverse knockin option differs from a standard option by the additional feature of an instrike price. Only if spot trades at or beyond the instrike 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, does the option come into existence. If the instrike is never triggered then the reverse knockin option expires worthless at expiration.

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

The instrike of a reverse knockin option differs from that of a knockin option in its location relative to spot and the strike of the option. The instrike of a reverse knockin option is such that the option knocks in as the option is gaining in value.

Reverse Knockin Option Image

Reverse Knockin Option – How It Is Used

Structurers often use the reverse knockin option as an alternative to a short European standard option.

Hedging Strategies

The reverse knockin option trades at a price that is close to the price of the equivalent European standard option, if the combination of strike and instrike are chosen appropriately. Given that the obligations of the seller of the reverse knockin are only an issue if the option is knocked in it adds an extra degree of comfort to short sellers. For example, a common hedging strategy is the trigger forward, where the hedger buys a European standard option call (put), and sells a reverse knockin option put (call) with the same strike price. The combination of options can be chosen to result in no net premium.

Trading Strategies

As for hedging strategies the reverse knockin is best used when sold to fund the purchase of another option. One example of this is where the trader buys a reverse knockout call (put) and funds the purchase by selling a reverse knockin put (call).

Reverse Knockin Option - Pricing Examples

Example 1

Maturity: 6 month Call/Put: EUR put / USD call Strike: 1.1200 USD per 1 EUR Outstrike 1.0500 USD per 1 EUR

Spot: 1.1232/35 USD per 1 EUR Swap: -0.00553/547 USD per 1 EUR ATM Volatility: 9.70/9.90

Price: 2.235% / 2.395% of EUR face

Equivalent standard European option: 2.82% / 2.88% of EUR face.

If spot does not trade at or below 1.0500 USD per 1 EUR prior to the expiration time on the expiration date, then the option is never activated and expires worthless. If spot trades at or below 1.0500 prior to the expiration time on the expiration date, then if spot finishes below 1.1200 at expiration the buyer of the option will sell EUR at 1.1200.

Reverse Knockin Option Pricing Example One Image

Example 2

Maturity: 3 month Call/Put: USD call / JPY put Strike: 121.00 JPY per 1 USD Outstrike 126.00 JPY per 1 USD

Spot: 120.40/45 JPY per 1 USD Swap: -0.353/-0.348 JPY per 1 USD ATM Volatility: 8.40/8.60

Price: 0.975% / 1.075% of USD face

Equivalent standard European option: 1.305/1.35% of USD face.

If spot does not trade at or beyond 126.00 JPY per 1 USD prior to the expiration time on the expiration date, then the option is never activated and expires worthless. If spot trades at or below 126.00 prior to the expiration time on the expiration date, then if spot finishes above 121.00 at expiration the buyer of the option will buy USD at 121.00.

Reverse Knockin Option Pricing Example Two Image