what is a knock out option 
a knock out option is an option with a built in mechanism to expire worthless if a specified price level in the underlying asset is reached a knock out option sets a cap on the level an option can reach in the holder s favor as knock out options limit the profit potential for the option buyer they can be purchased for a smaller premium than an equivalent option without a knock out stipulation a knock out can be compared with a knock in option understanding a knock out optiona knock out option is a type of barrier option barrier options are typically classified as either knock out or knock in a knock out option ceases to exist if the underlying asset reaches a predetermined barrier during its life a knock in option is effectively the opposite of the knock out here the option is activated only if the underlying asset reaches a predetermined barrier price knock out options are considered to be exotic options and they are primarily used in commodity and currency markets by large institutions they also may be traded in the over the counter otc market types of knock out optionsknock out options come in two basic types a down and out option is one variety it gives the holder the right but not the obligation to purchase or sell an underlying asset at a predetermined strike price if the underlying asset s price does not go below a specified barrier during the option s life should the underlying asset s price fall below the barrier at any point in the option s life the option expires worthless for example assume an investor purchases a down and out call option on a stock that is trading at 60 with a strike price of 55 and a barrier of 50 if the stock trades below 50 at any time before the call option expires then the down and out call option promptly ceases to exist contrary to a down and out barrier option an up and out barrier option gives the holder the right to buy or sell an underlying asset at a specified strike price if the asset has not exceeded a specified barrier during the option s life an up and out option is only knocked out if the price of the underlying asset moves above the barrier assume an investor purchases an up and out put option on a stock trading at 40 with a strike price of 30 and a barrier of 45 over the life of the option the stock hits a high of 46 but then drops to 20 per share too bad the option still would automatically expire because the barrier of 45 had been breached now if the stock hadn t gone above 45 and eventually sold off to 20 then the option would remain in place and have value to the holder advantages and disadvantages of knock out optionsa knock out option may be used for several different reasons as mentioned the premiums on these options are typically cheaper than a non knock out counterpart a trader may also feel that the odds of the underlying asset hitting the barrier price are remote and conclude that the cheaper option is worth the risk of unlikely being knocked out of the trade finally these types of options may also be beneficial to institutions that are only interested in hedging up or down to very specific prices or have very narrow tolerances for risk 