Knock-In Option

  

Categories: Derivatives

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 are stock options in 90 se...0 Views

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Finance allah shmoop what are stock options in ninety seconds

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or less Here's a stock ibm not the tech company

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This one makes an anti constipation drug It's trading at

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one hundred eighty bucks a share Okay so here's an

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option of buy a share of ibm anytime in roughly

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the next three months For one hundred ninety dollars a

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share it's called a call option If you really believe

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the ibm will go to say two hundred dollars a

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share in the next three months well you'd be what's

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called ten dollars in the money then or then have

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a stock option or call option with a strike price

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of one hundred ninety dollars which would then have intrinsic

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value of ten bucks a share On the other end

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of the buy sell desk is the gal willing to

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sell you that call option for three bucks Three bucks

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a premium So gut check time Would you pay three

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dollars for the right to buy a share if ibm

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for ten dollars higher than where the stock's trading now

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today Meaning that to break even in the next three

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months the stock has to trade all the way up

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from one hundred eighty dollars a share to one hundred

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ninety three dollars a share jobs for you to get

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your money back but it goes to two hundred two

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share Well if you sell that option you'll have invested

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three bucks a share for a net return of seven

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bucks in just three months or less And yes we're

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ignoring commissions and taxes here because well in problems like

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this or just a in the book but three dollars

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into seven only three months Yeah that's a great score

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You'd have more than doubled your money And on an

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annualized return basis that's over a nine hundred percent dish

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return really good score but with a much more likely

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case that you spend three bucks to buy the option

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and it expires totally worthless And then you've lost your

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entire investment in that option So that's a call option

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It's evil twin is a put option So whereas a

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call options the rightto by a security to set price

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by a certain set date a put option is the

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right to sell that option We'd go into more detail

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here but we're promised ninety seconds

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