knock-out option

CFA Level III
#1

An investor have the view that the USD will strengthen against the YEN over the next six months (current spot 120). He purchase a USD at the money call (120.0) with a knockout at 130.00. Cost: 1%.

Question: If the USD does strengthen and trades above 130.00 over the life of the option. (the call will expire worthless.)

Does it mean the investor will have 1% lost (knock-out option cost) or (130-120)/120 - 1% = 8.3% - 1% = 7.3% gain?

Many thanks!

#2

Can I say the combination of buying knock-out option is “buying an European call option at lower strike and selling an American call option at higher strike”?

Many thanks!

#3

Investor will face 1% loss if the USD trades above 130 any time during the life of the option - i.e. it will be ‘knocked out’.

I think it is reasonable to think about knock-out call option as buying a European call option at a lower strike rate and selling an American call option at a higher strike (knock-out level). This is also reflected in the lower premiums paid for the knock-out options. For example if you paid $10 for buying European call option and received $5 for writing American option at a higher strike (premium will be lower). The net $5 is what you will likely pay for this knock out option.

In practice, options can be constructed with varying degrees of exotic features.

#4

Thanks Zulu007!

But if we think knock-out call option as buying a European call option at a lower strike rate and selling an American call option at a higher strike (knock-out level), investor can still keep the 8.3% gain if investor is knocked out. (Above the knock out strike, net-net of two call options impact is 0) Sorry still confused…

#5

Good point.

You are right that buying a European call option at a lower strike rate and selling an American call option at a higher strike (knock-out level), investor can still keep the 8.3% gain if investor is knocked out. But here we are only using this as a reference to stick it in our brain. You can think of this as a small difference between the 2 combinations.

In knock out option, the investor will NOT keep the gain.

#6

Understood, thanks Zuzu!