Using knock-out options to lower the cost of hedging

Using knock-out options to lower the cost of hedging

Submitted by adil on Thu, 08/07/2014 - 20:00

Learn to Lower the Cost of Hedging!

One of the main advantages of knock-out options is that it cuts down the expense of hedging. Lower cost is needed in order to purchase this option. As a result, a trader has a hefty percentage payout if the option ends in money. Otherwise the trader faces minute loss in case it does not work out.

Types of knock-out options:

There are two types:          

Up-and-out---Through a particular point of price, the underlying asset’s price lifts up for it so that it may get knocked out.

Down-and-out---This is totally opposite. The underlying asset’s price slides down through a particular point of price so that it may get knocked out.

Knock-out options has two particular prices; the strike price and knock-out barrier price.

• A knock-out option yields a positive payoff if only the option is ‘in the money’ and the knock-out barrier is not broken. The knock-out option will act as a standard call or put option.
• The option gets knocked out immediately after the underlying asset approaches the knock-out barrier price. It doesn’t matter the asset’s price is trading above or below the barrier.  

Up-and-out example:

Let’s suppose there is a stock that trades at $100. A knock-out call option is bought by a trader for a strike price of $105 and a knock-out barrier for $110. These options are to be expired in three months and are acquired at $2 premium payment. During the three-month period of the option, if the stock trades higher than the $110 barrier price, it won’t exist anymore hence it’ll get knocked out. But in case the stock does not cross $110, the profit or loss of the trader depends on the stock price before or at the point of expiration.

Now if the stock trades lower than $105 prior to running out of the option, it expires worthless making a call of ‘out of the money’. In case if it trades above $105 but lower than $110 prior to the running out of the option, the call will be ‘in the money’ and it’ll have a gross profit that is equal to the stock price less $105. The net profit here is less $2. If the stock trades at $109.80 at or close to the point of expiration, trade’s gross profit will be leveled to $4.80.

Down-and-out example

Let’s assume that an exporter from Canada, by using knock-out put options, wants to hedge US Ten million dollars of export assets. He is anxious about the possible building up of Canadian dollar whose trading rate is presently US $1 =C$ 1.0800 in the spot market. He purchases a US Dollar put option that is to be run out in a month. The purchase is made with US $ 10 million notional value. The strike price is US $ 1= C$ 1/0900 and knock-out barrier is US $1= C$ 1.0800. This knock-out put costs C $ 50,000.

The exporter wagers if the Canadian dollar builds up, it won’t cross level of 1.0900. During the option’s one-month period if the US dollar trades under the C $ 1.0800 barrier price, it will get knocked out and won’t exist. If the trade is not lower than US $ 1.0800 then before or at the point of expiration of the option the exchange-rate will determine profit and loss of the exporter.

 Though knock-out options are considered to be opaque, the advantage of lower outlay makes these options more reliable.