Riddle time: what is an option that was never really an option?
Sounds like a meditation on the perception of free will in a universe that might be deterministic on a subatomic level. But...no. We're talking about financial markets.
In financial terms, options give investors the right, but not the obligation, to buy or sell an underlying asset (a stock or commodity or whatever) at a set price within a set period of time. So...you might purchase an option to buy 100 shares of XOM stock at $80 a share, with the contract expiring in June.
A knock-in option generally works like a normal option, except it has a barrier price built in. If the underlying asset never reaches a certain price threshold, then the knock-in option never becomes a true option. When it expires, it's like it never existed. However, if the minimum price threshold is met, the contract becomes a regular option.
You buy a knock-in option for XOM at $80 a share, with the contract expiring in June. It has a barrier price of $75 a share. The stock is currently trading at $70. If June comes around and the stock is trading at $73, the option doesn't exist. The contract just disappears into the gloaming, like a gauntleted Thanos just snapped his fingers.
However, if the stock gets to $76 in late May, then the contract becomes a live option. Now you just need it to rise above $80, so you can exercise the option and book a profit.
Related or Semi-related Video
Finance: What Is a Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
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