What is the Down-and-Out Option?

Derivatives, especially options contracts, have provided tremendous profits to experienced investors who understand the technicality of the derivative contract. They are considered incredibly complex as they include numerous strategies that investors and traders create to ensure they realise the highest returns. Some options contracts are straightforward and do not include complex strategies and factors. However, some options contracts are exotic and provide returns based on the fulfilment of an underlying event or situation. One such option is called the Down and Out Option.

Down and Out Option

The meaning of the down and put option is attributed to its exotic nature, where the option defines the payout based on the fulfilment of certain price action. Down and out options are types of options that pay the investors only when the current price fluctuates enough from the strike price(the price at which the options contract can be exercised) to reach a predefined level. A down and out option is also called a barrier option. It is a type of derivatives that pays the investor only when the underlying asset has reached or exceeded a predetermined level

However, the nature of payout entirely depends on the type of down and out option the contract is. There are two types of down and out options:

  • Knock-in Down and Out Option: This type of down and out option expires without any value if the underlying asset does not reach a predetermined price level. Knock-in down and out options are of two types; up-and-in and down-and-in. In up-and-in, the contract becomes binding when the underlying asset’s price exceeds the pre-specified price. When it moves below the pre-specified price, the contract is called down-and-in.
  • Knock-out Down and Out Option: This type of down and out option expires without any value if the underlying asset exceeds a certain price. Knock-out down and out options are of two types; up-and-out and down-and-out. In up-and-out, the contract becomes worthless when the underlying asset’s price exceeds the set predefined price. When the underlying asset’s price moves below the set predefined price, the contract is called down-and-out and expires worthless.

Using Down and Out Options

Down and out options are one of the hardest options to value, owing to their complex nature. Hence, only large institutions or entities make use of down and out options who have extensive knowledge of the market factors and the technicalities included in trading options contracts. A portfolio manager may use down and out options to hedge against the losses when the positions are held for the long term as the cost of down and out options is lesser compared to other options contracts. Generally, down and out options have cheaper premiums as they come with prior conditions. Hence, if a trader thinks that the contract's set price is unlikely to be reached, they can buy a knock-out down and out option. On the other hand, if the trader wants to hedge a position based on the price reaching a certain level, then buying a knock-out down and out option would be the ideal choice.

However, if investors use the down and out options for personal gains, they must ensure that the positions are adjusted based on the underlying asset’s price direction. If not, knock-in and knock-out down and out options can force the investors to incur hefty losses. Hence, it is important to consult a financial advisor before opting to trade using down and out options.

Final Word

Definition of the down and out option may seem complex, but if you understand in detail the down and out option meaning, you can trade effectively using them. Down and out options use the principle of barriers, where a price is set for a payout before the contract becomes binding.

Since the payout is based on the assumption that the contract price will fall, reach or exceed the strike price, you must base your decisions on factual analysis. Once you have analysed the market factors and the underlying asset and have concluded that the price will head in a certain direction, you can trade using a down and out option.

In case of any further assistance, you can consult a financial advisor of IIFL or visit IIFL’s website to gain knowledge on how to trade using down and out options.