22 July, 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 15 - Reverse Knockout Option

Reverse Knockout Option Introduction

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

Reverse Knockout Option

Reverse knockouts are one of the most widely used barrier options. Although they were introduced to the market much later than knockout options, their use became far more widespread far more quickly. Reverse knockouts are most often used to express a directional view.

Features

The reverse knockout option differs from a standard option by the additional feature of an outstrike price. 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 reverse knockout option at expiration is identical to that of the equivalent standard European option. The profit from a reverse knockout option is limited to the intrinsic value between the strike price and the outstrike price.

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

The outstrike of a reverse knockout option differs from that of a knockout option in its location relative to spot and the strike of the option. The outstrike of a reverse knockout option is chosen such that the option knocks out as the option is gaining in intrinsic value.

Reverse Knockout Option Image

Reverse Knockout Option – How It Is Used

Trading Strategies

The reverse knockout option is ideally suited to expressing directional views, and is not suitable as a hedging instrument. European standard options offer the holder unlimited upside. However, even in long trending markets, the spot market does not move in a sudden straight line. The reverse knockout is therefore ideal for expressing a limited directional view within a specific time period. The great advantage of a reverse knockout is that it typically trades at a fraction of the cost of the equivalent European standard option.

Hints for structurers:

  1. Typical maturities for reverse knockout strategies are three to six months.
  2. Strike if often chosen to be at or around current spot.
  3. Barriers are usually of the order of 0.85 standard deviations away from strike (if set around current spot) for attractive discounts relative to the equivalent European standard options.
  4. The greater the distance between the strike price and the barrier, the greater the width of the two way price.

Reverse Knockout Option - Pricing Examples

Example 1

Maturity: 6 month Call/Put: EUR put / USD call Strike: 1.1400 Outstrike 1.0600

Spot: 1.1409/15 Swap: -0.00569/562 USD per 1 EUR ATM Volatility: 9.70/9.90

Price: 0.655% / 0.845% of EUR face

Equivalent standard European option: 2.915% / 2.985% of EUR face.

If spot trades at or below 1.0600 prior to the expiration time on the expiration date, then the option terminates. If spot does not trade at or below 1.0600 prior to the expiration time on the expiration date, then the buyer of the option will sell EUR at 1.1400 if spot is at or below that level at expiration.

Reverse Knockout Option Pricing Example One Image

Example 2

Maturity: 3 month Call/Put: USD call / JPY put Strike: 120.00 Outstrike 125.00

Spot: 119.80/85 Swap: -0.360/-0.355 JPY per 1 USD ATM Volatility: 8.25/8.45

Price: 0.285% / 0.385% of USD face

Equivalent standard European option: 1.415/1.485% of USD face.

If spot trades at or above 125 prior to the expiration time on the expiration date, then the option terminates. If spot does not trade at or above 125 prior to the expiration time on the expiration date, then the buyer of the option will buy USD at 120 if spot is at or above that level at expiration.

Reverse Knockout Option Pricing Example Two Image

Reverse Knockout Option Risk Management Considerations

Spot Order Management

An important consideration in managing a portfolio of reverse knockout options is the efficient management of spot orders at the barrier. It is essential that reports are generated on a daily basis that recalculate the order required to de-hedge the option at the barrier so that the orders with the spot desk can be updated. It is also important to generate a report that indicates which spot orders are most likely to be executed and in the short term. It should be remembered that to estimate which orders on most likely to be triggered, the distance between current spot and the barrier must be measured in standard deviation terms, not simply in percentage terms. In other words, the relative volatility of the currency pair must be taken into account.

Another consideration of spot orders associated with the outstrike of a reverse knockout option is whether the client requires immediate notification of a barrier event. If the client requires 24-hour notification of a barrier event, then the client’s contact details should be included to with the order with instructions to call the client.

“Bad Deriv”

When you are short a reverse knockout you are short dVega/dVol, and dVega/dSpot. This means that for a short reverse knockout position, which would be long vega, you would have the following risk:

dVega/dVol – As volatilities increase you would derive into a shorter vega position, and need to buy vol at a high level. As volatilities decreased you would derive into a longer vega position, and need to sell volatility at a low level. Therefore as vols moved you would lose money rehedging your vega position. A short dVega/dVol position is the volatility equivalent of a short gamma position.

dVega/dSpot – As spot moves either towards the barrier, or out of the money, then the long vega position starts to reduce. Therefore, effectively the position gets short vega in a moving market, when vols should move higher, and stays long vega in a stable market where vols should move lower.