What is an Up and Out Option?
A popular adage is, “you cannot time the markets”. However, options provide a way for investors to decide whether to buy or sell the underlying in a given timeframe. Traders use them to hedge their positions and protect against downside risk (losses) or enhance their gains (profits).
Options are derivatives that give the trader an option to buy ‘call’ or sell ‘put’ a security at a given time. The up and out option is a type of barrier option that the traders use to get additional protection or leverage during a trade.
This blog details what the up and out option is, and the definition of up and out option.
Up and Out Option
The up and out option is a type of barrier option that traders use because they are path-dependent. These options are dependent on stocks reaching a particular pre-specified barrier before the expiry of the option.
The barrier price is the price of the security that is specified in a barrier option to cross.
There are two types of barrier options. These are Knock-out (KO) options and Knock-in (KI) options.
The KO option expires whether or not the underlying security reaches the barrier level.
The KI option comes to play only if the underlying security crosses the barrier option price.
One can further divide the barrier option into ‘Up’ and ‘Down’ based on the movement of the price of the underlying security.
Why does a trader exercise the up and out option?
The trader exercises the up and out option if they feel that the prices of the underlying asset are going to either remain stable or decrease over a specific period. With the up and out option, both the parties (buying and selling) agree on a price called the strike price. At the strike price, traders of both sides can buy or sell if the price crosses the barrier level. In this case, the traders do not have to buy the option at a premium.
Up and out options can have multiple-barrier levels. Each of these barriers has a pre-specified date attached to them. Traders can buy or sell the underlying asset by exercising the ‘call’ or ‘put’ option if and when the prices cross each of the multiple barriers.
The up and out option meaning
The up and out barrier option ensures that the trader has the option to buy ‘call’ or sell ‘put’ the option if the underlying security cannot reach the barrier or if it crosses the barrier.
A trader will want to exercise ‘call’ if the security is unable to reach the barrier spot. If the underlying security breaches the barrier price, the trader has the option to exercise ‘put’.
The up and out option example
Here is an example to explain the meaning of the up and out option in detail.
Suppose a trader is entering into a contract with another trader with the up and out option. The trader has purchased 100 stock units at the price of 200 per share. Therefore, the total value of all the shares is Rs.20,000 only.
In the above contract, the traders agree on a barrier level of Rs.210, a strike price of Rs.205 and an expiry term of 15 days.
The trader taking another trader into the contract agree on a premium price of Rs. 1 per share. Therefore, the traders agree on an option premium of Rs. 100.
Consider that the price of the stock increases to 209.60 at the end of the 15th day. The stock price could not cross the Rs. 210 barrier spot. The traders now have the option to buy the stock at the agreed strike price of Rs. 205. Thus, they will make a profit of Rs. 4.60 per share. Therefore, the total profit of the trader would be Rs. 4.60 multiplied by 100, which is equal to Rs. 460.
After subtracting the premium amount of Rs. 100, the trader will still make a profit of Rs.360 on exercising the up and out option.
In another scenario, consider if the price breached the barrier of Rs. 210 within 15 days. Therefore, as the name suggests, the option will be out of money and the trader will not be able to exercise the up and out option. The trader will also lose the premium money paid, which is Rs. 100 in total here because he was unable to exercise the option. However, this premium amount of Rs. 100 will be the other trader’s profit with whom this trader entered into the contract. One trader’s loss of opportunity is another trader’s opportunity in an up and out option.
The up and out option is a good choice if the trader feels that the price of the underlying security is going to be stable or will increase over a specific period.
It can also be beneficial to use the up and out option in multiple barriers and have an option to exercise them in each one of them. This type of contract requires two traders to enter and the loss of one trader’s opportunity can be a potential opportunity for the other. There are other types of barrier options as well, but the up and out option can be easier to exercise if the prices remain less volatile in the short term. This option can help the trader strike balance between stability and stock price leverage.