Up-and-Out Option

An up-and-out option is a barrier (exotic) option that becomes worthless if the underlying asset’s price rises to or above a predetermined barrier level during the option’s life. If the barrier is never hit, the option behaves like a standard (vanilla) call or put, giving the holder the right — but not the obligation — to exercise at the strike price by expiration.

Key takeaways

• An up-and-out option is knocked out (expires worthless) if the underlying rises to or above the barrier level at any time before expiration.
• It can be a call or a put; both are voided when the barrier is breached.
• Up-and-out options are typically cheaper than comparable vanilla options because of the risk of being knocked out.
• The opposite knock-out type is a down-and-out option (knocked out if the underlying falls below the barrier).
• A knock-in option is the complementary structure: it has no value until the barrier is reached.

How it works

A barrier option’s payoff and existence depend on whether the underlying asset reaches a preset price level:
* Knock-out: The option ceases to exist once the barrier is reached. Hitting the barrier even briefly knocks out the option permanently.
* Knock-in: The option comes into existence only if the barrier is reached.

For an up-and-out option, the barrier is above the initial asset price. For example, if a call has strike $80 and a barrier of $100, the option will be void if the underlying ever trades at or above $100 during the contract period, regardless of later price moves.

Uses and pricing

• Typical users: large institutions and market makers structure these instruments over the counter to meet specific hedging or speculative needs.
• Cost: Because of the knockout feature, premiums are generally lower than for vanilla options with the same strike and expiration. Pricing still reflects standard option inputs (underlying price, volatility, time to expiration, interest rates) plus the barrier feature.
• Liquidity: These are often OTC and less liquid than exchange-traded vanilla options, so buyers may take the premium offered or negotiate bespoke terms with a dealer.
• Hedging: An up-and-out option can reduce hedging costs versus a vanilla option but is imperfect — protection is lost if the underlying rises above the barrier.

Example

An institutional investor wants 100 call contracts on stock currently trading at $200. They expect the price will rise but not exceed $240 in three months. Two choices:

1. Vanilla call: strike $200, three-month premium $11.80 per share → $1,180 per contract. For 100 contracts (100 shares each), cost = $118,000.
2. Up-and-out call: same strike and expiration, barrier $240, quoted premium $8.80 per share → $880 per contract. For 100 contracts, cost = $88,000.

The up-and-out saves $30,000 in premium. Breakeven for the buyer is $200 + $8.80 = $208.80. The buyer profits only if the stock rises above $208.80 but remains below $240. If the stock touches $240 at any time before expiration, all options are knocked out and the $88,000 premium is lost.

Practical considerations

• Risk of total premium loss if the barrier is touched.
• Breakeven and profit windows can be narrower than for vanilla options.
• Counterparty and liquidity risk are higher in OTC trades.
• Use them when cost savings justify the risk of losing protection if the price moves beyond the barrier.

Conclusion

Up-and-out options offer a lower-cost alternative to vanilla options for traders who believe the underlying will move in a favorable range but are willing to forgo protection if it rises above a specified barrier. They are useful for bespoke hedges and structured trades but carry the risk of outright nullification and typically trade OTC with limited liquidity.