Knock-Out Option
Categories: Derivatives
It’s like a slaughter rule in options trading. The knock out clause puts a cap on the amount that can be earned on an option trade.
Shares of Punch Services Ltd. trade at $10. You buy an option that allows you to purchase 100 shares at $12 a share. If the stock rises to $13, you can exercise the option, buy at $12 and immediately sell at the market price of $13. You earn a profit of a dollar per share (minus the cost of the option). The further beyond $12 the stock rises, the more you make.
A knock out clause puts a cap on this. If your option has a knock out at $15, then if the share price of Punch Services gets above $15, then the option becomes worthless.
So why buy a knock out option? Because it’s cheaper. The upside is limited (less risk to the person who sold it to you), but your cost is lower...more chance of profit for moderate stock increases.