Introduction
Well, we have been hearing so many terms in the financial world. You come across terms like structured investments, structured products, call/put options in equity, referencing assets, and many others.
Most investors just do not understand the real meaning of these terms and end up signing investment documents. However, mid-way we all get stuck after all. While a well-informed investor learns what the concept is and then goes for an investment choice.
On this note, let us quickly discover what structured notes knockout is all about:
A knock-out option is a predominantly type of option that resembles a deal. When the price of an underlying asset reaches a certain point, the deal stops working. This point can be lower or higher than the current selling price of the underlying asset. The investor therefore does not profit more than the pre-designed points the asset value reaches.
In a nutshell, the knock-out level options are deals that are linked to prices. The lower initial costs of underlying assets provide a safety net to investors against their capital investment.
A deeper understanding of the knockout mechanism in investment products
The knockout mechanism limits the profit potential for the option buyer. However, you can purchase specific types of knock-out products for a smaller premium amount over an option without a knock-out stipulation.
Therefore, the knock-out option is a type of barrier option indeed. The initial caps are set to the underlying assets of structured notes and once prices reach par or above the barrier limits, the deals are closed and the notes stand redeemed. The profits are limited to the cap values on assets.
The basic idea behind including a knock-out barrier mechanism in investment or structured products is to limit potential losses and still be able to lock in profits.
How do structured notes knockout options work as Investments?
As is said already, the knockout mechanisms operate in a similar way to barrier investments. If you have a look at it, barrier options are created as knock-out and knock-in.
Under a knock-out option, the price of the asset is determined by the market conditions and is called the strike price. Here, due to the volatility of bearish or bullish scenarios, the cost of the underlying assets may go way too high or way too low as compared to the strike prices. And, it is then that the option stops working.
The premiums in a knock-out option are lesser than what you find with options without the knockout.
When you have a look at it, the knock-in option works quite opposite to how the knockout mechanism works. Under the knock-in option, the option is activated once the asset reaches the predetermined value of its barrier price.
In a way, the options market works much differently as compared to commodity and currency markets. The investor does not buy at a lower price and sell the equity at a higher price as you find in a regular option.
The knock-outs have specified price levels capped for underlying assets of structured products and the option helps investors leverage their profits or losses.
Major categories for structured products knockout
These are the two main types of knock-out options and they are classified into:
- A down-and-put option
- Up and out option
Let us look into each of the above:
1. A down-and-out option
The down-and-out option is a type wherein the underlying assets are bought by investors at pre-determined strike prices. A strike price refers to the capped values below which the shares or assets cannot be bought and sold.
The criteria is that the said asset values must not go below the predetermined barrier price values.
In case, the underlying stock price falls below the barrier or strike prices, during the term of the asset, then the option expires worthless. In other words, the option becomes zero value for the investors.
Henceforth, you find things work way differently from an equivalent option without a knock-out.
1.1 An example with a worked-out illustration
Suppose the price of the underlying security values at $60 under a down-and-out call option. Here, the strike price stands at $55 and the barrier cap is $50.
Now, in case the stock or share is trading for $40 which is the price below the barrier cap, then, the option ceases to exist despite the strike price. This is how a knockout level works!
2. Up-and-out option
This option works exactly the opposite of how the down-and-out option works. Here, the investor can exercise this option only if the underlying asset’s price does not exceed the barrier level. In other words, an up-and-out option is knocked out only if the value of the asset goes above the barrier price.
Here, the options include a hike in strike prices that leads to the null value of the asset because the price of an asset is higher than the set barrier level.
As a general thumb rule, a knockout arises when the price reaches a certain level or exceeds barrier benchmarks.
2.1 An example with a worked-out illustration
The investor has bought a share or a stock under an up-and-out option. Its purchase price is valued at $40 per share. The strike price is $30 and the barrier price is $45.
This particular stock hits an all-time high of $46 at the equity market but drops to $20 per share, the investor still loses the value of this asset as it has breached the barrier by going above $45. It is unfortunate that despite the fact the value of the underlying asset rises in this case scenario, the investor still loses the value of his/her investment.
Had the stock not hiked to $45 but remained put at $20 to be sold to another buyer, then the option would have pretty much remained the same, adding some kind of value to the investor. Here is how specific price level is capped under this type of knock-out barrier option. The payoff depends on whether the asset reaches the cap limits or not!
Now, have you understood how the up-and-out put option works?
Analyzing the pros and cons of knockout investments
Like any other investment plan, knockout plans also have their own set of pros and cons. Let us dive into what the Pros are
Pros of structured notes knockout
1. Lower Premiums
The premiums on knockout investment products work cheaper than the premiums that are levied for non-knock-out counterparts. Therefore, there is a lower amount premium than an equivalent option without the knockout. The investors are exposed to losses if underlying security falls below pre-determined levels or if prices hike barrier levels which is why premiums are lower-priced.
2. Lower level of risk-tolerance
The knockout options are more suitable for buyers who have very narrow levels of risk tolerance. Therefore, they feel that the cheaper option is worth taking the risk over completely being knocked off the trades. And, most investors feel that the stocks never fall to a specific price limit as stated on the barrier caps. In a nutshell, these options are considered low-risk as compared to knock-out warrants without a stop-loss.
3. Multiple opportunities for hedging
The knock-out options work best for hedging the prices up or down amongst institutional investors as they can limit or set caps to very narrow price ranges. Financial institutions also benefit immensely by hedging their asset or investment values from time to time. The price level in the underlying asset plays a great role here. In a way, this is a type of exotic option within the “structured notes” category wherein when the security falls to a specific cap, it ceases to exist.
Cons of structured notes knockout
These are the following disadvantages of knock-out options:
1. Vulnerability of volatility in markets
Equities or shares are exposed to bearish or bullish markets. Therefore, the pricing of stocks or equities going below or above barrier prices is higher on the cards. This can make the value of the underlying assets go penniless. In other words, the investor loses the complete value of the asset.
2. Limited profit margins
High net-worth individuals who are used to hitting jackpot prices for their assets may not find the knockout options very lucrative. This is because caps are always set to pricing hikes of stocks or investments limiting the amount of profits you can make on the asset portfolio. In a nutshell, knock-out options limit the profit margins of investors on the whole.
3. Accessible only to a select group of investors
Knockout options are only available to a select group of investors. The notes with knockout capabilities are usually so high that only financial institutions or high-worth institutional investors get access to this kind of investment portfolio.
Knock-out vs. knock-in options
In the case of a knock-in mechanism, it is the opposite thing that happens here. A pre-determined set barrier price of the underlying asset is fixed.
Only if the asset reaches the price, the call options for the asset get activated. The investment is named the knock-in barrier option.
Worked out the example of a knock-in-action
Let us assume an investor purchases a note wherein the strike price of a share is $40 and the barrier price is $50, here the asset is activated as a regular call option only when the value of the underlying asset reaches $50 and above. The option is then created with the strike price of the asset that gets valued at $40 as the price of the stock reaches a predetermined level.
On a general note, investors must understand that the knock-out level for an underlying asset is reached or the asset falls below a specified price. The specified barrier during the option’s life determines the actual underlying asset price whose compensation may impact the final redemption for the investor.
Therefore, it is the knock-out event that determines the life of the option here. These notes can be traded in the over-the-counter markets too.
The Bottom Line
As of now, only institutional agencies and high-net-worth institutional investors have access to structured note knockout options. The options work similar to currency markets by large institutions. The option is purchased for a small premium amount while it expires worthless if the underlying asset reaches a price level higher or lower than barrier price tabs.
Therefore, these options are a tad more complex than regular stocks and bonds. This is because the knock-out options limit the profit potential when the underlying asset’s price gets breached as such. In a crux, the underlying asset’s price exceeds or falls can add to offers that appear lucrative to investors.
The pricing dynamics between knockin and knockout prices may be a little complex to understand at the beginning of your trading career. Eventually, once you start trading regularly with such investment options, you may get a hang of the same. These are exotic options for investments that only financial institutions and institutional investors can afford. That primarily explains how the notes are purchased for a smaller premium than the equivalent of an option without the knock-out.
The note ceases to exist if the underlying asset or the underlying security reaches the knock-out position. In a nutshell, the knock deals are considered exotic options that can be used in commodity and currency transactions too.
