Newsletter Subscribe
Enter your email address below and subscribe to our newsletter
What is a Knock-In Option?
A Knock-In Option is a type of barrier option that becomes active only if the underlying asset reaches a predetermined price level known as the barrier. Until this barrier is triggered, the option does not exist or cannot be exercised.
Definition
A Knock-In Option is a derivative contract that activates when the underlying asset’s price hits a specified barrier level during the option’s lifetime.
Key Takeaways
- The option activates (“knocks in”) only when the barrier is reached.
- Common in structured products and advanced hedging strategies.
- Can reduce option premiums due to conditional activation.
Understanding Knock-In Options
Knock-In Options belong to a family of exotic options known as barrier options. Unlike standard options, barrier options require price-based activation conditions.
There are two main types:
- Up-and-In: Activated when the asset price rises to or above the barrier.
- Down-and-In: Activated when the asset price falls to or below the barrier.
These options provide lower premiums compared to vanilla options because the payoff only becomes possible once the barrier is triggered. Traders use them for cost-efficient hedging or speculative strategies.
Formula (If Applicable)
There is no simple formula for pricing Knock-In Options, but they are typically priced using:
- Black–Scholes adjustments
- Monte Carlo simulations
- Partial differential equation models for barrier features
Real-World Example
A trader purchasing an up-and-in call on a stock at $50 with a barrier of $60 will only activate the option if the stock price hits $60 during the option period. If the barrier is not reached, the option expires worthless, regardless of later price movements.
Importance in Business or Economics
Knock-In Options help companies and investors reduce hedging costs, structure customised risk profiles, and manage exposure to specific market movements. They are widely used in corporate finance, structured notes, and derivatives trading.
Types or Variations
- Up-and-In Options
- Down-and-In Options
- Knock-In Calls
- Knock-In Puts
Related Terms
- Knock-Out Option
- Barrier Option
- Exotic Derivatives
- Black–Scholes Model
Sources and Further Reading
- https://www.investopedia.com/terms/k/knockinoption.asp
- https://www.cfainstitute.org/en/research/foundation/2016/barrier-options
Quick Reference
- Core Idea: Option activates only if the barrier is reached.
- Primary Use: Lower-cost hedging and structured products.
- Impact: Conditional risk exposure and reduced premiums.
Frequently Asked Questions (FAQs)
Do Knock-In Options always become active?
No, only if the barrier price is reached.
Why are Knock-In Options cheaper?
Because activation depends on meeting a price condition, reducing the chance of payoff.
Are Knock-In Options risky?
Yes, they may expire worthless even if the underlying asset later moves favourably.
