what is an up and out option 
an up and out option is a type of knock out barrier option that ceases to exist when the price of the underlying security rises above a specific price level called the barrier price if the price of the underlying does not rise above the barrier level the option acts like any other option it gives the holder the right but not the obligation to exercise their call or put option at the strike price on or before the expiration date specified in the contract understanding up and out optionsconsidered an exotic option an up and out option is one of two types of knock out barrier options the other type of knock out barrier option is a down and out option both kinds come in put and call varieties a barrier option is a type of option where the payoff and the very existence of the option depends on whether or not the underlying asset reaches a predetermined price a knock out will expire worthless if the underlying reaches a certain price limiting profits for the holder and limiting losses for the writer the critical concept for a knock out option is that if the underlying asset reaches the barrier at any time during the option s life the option is knocked out and will not come back into existence it does not matter if the underlying moves back below pre knock out levels for example an up and out option has a strike price of 80 and a knock out price of 100 at the option s inception the price of the stock was 75 but before the option was exercisable the price of the stock reached 100 this valuation means the option automatically expires worthless because it hit or exceeded the barrier level it does not matter where the underlying trades before the exercise date a barrier option can alternatively be constructed as a knock in in contrast to knock outs a knock in option has no value until the underlying reaches a certain price up and outs can also be compared with down and out options with a down and out option if the underlying falls below the barrier price the option ceases to exist an up and out option can be a call or put both get knocked out if the underlying rises above the barrier price using up and out optionslarge institutions or market markers create these options via direct agreements with clients seeking them for example a portfolio manager can use them as a less expensive method to hedge against losses on a short position the hedge would be less costly than buying vanilla call options however it would be an imperfect hedge because the buyer would be unprotected if the security price increased above the barrier price pricing still depends on all the regular options metrics the knock out feature adding an extra dimension since options trade over the counter there is typically limited liquidity for such instruments this means the buyer will need to accept the premium cost offered to them or else attempt to negotiate a better price with the seller vanilla option premiums can provide a baseline estimate to work off of typically an up and out call option should have a lower premium than a vanilla call option with the same expiration and strike example of an up and out optionas an example assume that an institutional investor is interested in buying calls on apple inc aapl because they believe the price will rise they need to buy 100 contracts so they want to keep the cost as low as possible they consider buying an up and out option since they tend to be cheaper than similar vanilla calls say that apple stock is trading at 200 the investor believes the price will rise above 200 over the next three months but probably won t rise above 240 they decide to buy an at the money up and out option with a strike price of 200 an expiration in three months and a knock out level of 240 a vanilla option expiring in three months with a 200 strike is trading for 11 80 or 1 180 per contract which includes 100 shares the investor needs to buy 100 contracts for a total cost of 118 000 they have received a quote that an investment bank will offer them the up and out for 8 80 for a total cost of 88 000 8 80 x 100 shares x 100 contracts this saves the firm 30 000 on premium costs the investor s breakeven is 200 plus the cost of the option 8 80 or 208 80 apple stock needs to move above 208 80 within the next three months in order for the investor to cover the cost of the options they make money if the price of apple trades above 208 80 but also remains below 240 if at any time before expiration the price of apple stock touches 240 the options cease to exist and the investor loses the premium they paid 88 000 