Down-and-out option - Meaning, Working, Benefits and Drawbacks

In the first scenario, with the stock’s price above the barrier price, the down-and-out option limited your downside risk to Rs 5. Thus, with a down-and-out option, you hedge yourself from potential losses if the price of an underlying asset stays above a certain level.

Advantages of the down-and-out option

Given below are the advantages you get with a down-and-out option:

• Risk management

This is the primary advantage of the down-and-out option. You can use it to protect yourself against downside risk. By setting a barrier price below the current market price, you can ensure that you are exposed to price movements above the barrier price. If the price falls below the barrier price, the option becomes inactive and provides no further downside risk.

• Offers tailored protection

You can customise the down-and-out option per your specific risk tolerance and investment goals. You can choose the strike price and the barrier price, which allows you to align the option according to your risk-reward preference.

• Create a balanced portfolio

Integrating the down-and-out option into a mix of assets can create a more balanced and risk-managed portfolio. This helps you reduce the impact of market volatility.

Drawbacks of the down-and-out option

While a down-and-out option has advantages, it has its share of certain drawbacks. Some of them are as follows:

• Barrier risk

The effectiveness of the down-and-out option stays when the underlying asset's price is above the barrier price. If it drops below it, the option loses its worth and effectiveness. 

• Limited protection period

This is another major drawback. The down-and-out option remains in force only during a specific time frame until the expiration date. If adverse price movement happens after the option’s expiration, the option is no longer effective.

• Complex

Down-and-out options can be complex financial instruments, especially if you are a new investor. Understanding their potential outcomes can be quite challenging, and any mistake can lead to significant losses.

• Premium cost

Opting for a down-and-out option involves paying a premium. If the barrier isn’t breached, this premium leads to an additional cost that can reduce potential profits or enhance losses if the option isn’t exercised.

In conclusion

As evident, a down-and-out option works effectively as long as the asset's price is above the barrier price. That said, it can be a valuable tool for risk Summary: With a down-and-out option, you can exercise a put or call option as long as the price of the underlying asset is above a certain level. If it drops below it, the option gets knocked out.

Imagine you purchase car insurance to cover damages to your car. You pay a certain premium to the insurance company against which you get a sum insured, i.e., the maximum coverage limit. Now, your insurance company will cover damages up to the sum insured. If it exceeds it, you need to foot in the remaining expenses from your pocket.

Similarly, in options trading, a down-and-out option gives you the right to exercise a put or call option as long as the underlying security price stays above a certain level, known as the barrier price. If the underlying asset's price hits the barrier price or goes below it, the options contract never activates and is considered knocked out. Therefore, a down-and-out option is also called a knock-out option.

Working of the down-and-out option

Let’s understand the working of the down-and-out option with the help of an example. Suppose, a certain stock XYZ is trading at INR 100 per share. You get into a down-and-out option for this stock at a strike price of INR 110 and a barrier price of INR 90 with an expiration date three months from now.

Now, suppose over the next three months, the stock’s price remains above the barrier price of INR 90, and on the expiry date, the stock is trading at INR 105. In this case, the down-and-out-option retains its value, and you have the right (but no obligation) to purchase the option at the strike price of INR 110. However, since the stock’s price is below the strike price, it would be more favourable for you to buy the stock at INR 105.

If, however, the stock’s price drops to INR 85 over the next three months, the down-and-out option gets knocked out as the stock’s price has fallen below the barrier price of INR 90. With the option losing its worth, you don’t have the right to purchase the stock at the strike price of INR 110.

Management from unexpected price fluctuations in the financial markets.