Down-and-Out Option: What it is, How it Works

What Is a Down-and-Out Option?

A down-and-out option is a type of exotic option known as a barrier option. These options define the payout conditions based on whether the price falls enough from the strike price to reach a designated barrier price. What happens at the barrier price depends on what kind of barrier option it is, either knock-in or knock-out.

Understanding Down-and-Out Options

Considered an exotic option, a down-and-out option is one of two types of knock-out barrier options, the other being an up-and-out option. Both kinds come in the put and call varieties. A barrier option is a type of option where the payoff and the very existence of the option depend on whether or not the underlying asset reaches a predetermined price.

A barrier option can be a knock-out or a knock-in. A knock-out means it expires worthless if the underlying reaches a certain price, limiting profits for the holder and limiting losses for the writer. The barrier option can also be a knock-in. As a knock-in, it has no value until the underlying reaches a certain price.

The critical concept is if the underlying asset reaches the barrier at any time during the option's life, the option is knocked out, or terminated, and will not come back into existence. It does not matter if the underlying moves back to pre-knock-out levels.

For example, a down-and-out option has a strike price of 100 and a knock-out (barrier) price of 80. At the option's inception, the price of the stock was 95, but before the option was exercisable, the price of the stock reached 80. This valuation means the option automatically expires worthless even if the underlying hits 100 before the expiration date.

A down-and-out option can be a call or put. Both get knocked out if the underlying falls to the barrier price. For an up-and-out option, if the underlying rises to the barrier price, then the option ceases to exist. Both calls and puts cease to exist if the underlying rises to its barrier price.

Using Down-and-Out Options

Large institutions or market markers create these options by direct agreement, for the primary reason that valuing them is a complex undertaking. For example, a portfolio manager can use them as a less expensive method to hedge against losses on a long position. The hedge would be less costly than buying vanilla put options. However, it would be imperfect since the buyer would be unprotected if the security price decreased below the barrier price.

Pricing depends on all the typical options metrics with the knock-out feature adding an extra dimension. European style expiration means the exercise may only happen at the expiration date. The alternative would be an American-style option, where the holder may exercise the option at any time on or before expiration.