Down And Out Option

Down-and-Out Options
Nicole Voelker

Related Terms:
Barrier Options – an option that’s existence is dependent on the underlying security hitting a particular trigger price.
Knock-Out Options – the most common type of barrier option. One common knock-out option is the “down-and-out” option.

A down-and-out option is “a type of knock-out barrier option that ceases to exist when the price of the underlying security hits a specific barrier price level. If the price does not reach the barrier, the investor has the right to exercise their European call or put option at the exercise price specified in the contract.”

Assume we buy a call (down-and-out) option on April 1 when the price of the stock is $95. The option has a strike price of $100 and an exercise date of June 1. However, because it is a down-and-out option, it has the following stipulation. If the price drops to $80 or below anytime before the exercise date, the option is automatically worthless. Therefore, if on May 1 the price of the stock drops to $80, the option is worthless, even if the stock price is $110 by the exercise date of June 1.

Lower premium since option has value within a smaller price range. Lower costs make barrier options in general one of the most popular exotic options.
Seller has less risk of loss related to a regular option.

Barrier options require the addition of two inputs to the normal Black and Scholes inputs. These inputs are barrier level and barrier type (knocked in or knocked out.) Because of these additional factors either the Monte-Carlo or binomial option pricing model is recommended.


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