A knock-in option is an option that only comes into force — or knocks in — if the underlying asset reaches a certain price. In foreign exchange, the underlying asset is an exchange rate.
Imagine you’re a US business that needs to pay an EU supplier €5,000 by the 10 May 2021. You don’t have any Euro, so you’ll need to exchange your Dollars.
You’re worried that the EUR/USD exchange rate is going to go up and make the transaction more expensive. So, in order to protect yourself, you buy a knock-in option.
This option will knock in if the EUR/USD exchange rate goes up to 1.30 before your bill is due on the 10 May.
If the 10 May comes and goes and the EUR/USD exchange rate is never even close to 1.30, nothing happens. It’s like the knock-in option never existed.
But if the EUR/USD exchange rate reaches 1.30 before the 10 May, the option will knock in.
When a knock-in option knocks in, it works like a normal option.
To use our example, you’ll have the right — but not the obligation — to exchange Dollars for Euro at an exchange rate you’ve agreed in the option contract.
Like traditional options, knock-in options act as insurance. They give you something to fall back on if the market doesn’t go your way and you stand to lose money.
The main difference is that, because the market exchange rate has to reach a certain threshold — traders call this threshold a ‘barrier’ — knock-in options tend to be cheaper to buy than other types of options.
- There are two main types of knock-in option:
- As the name suggests, an up-and-in knock-in option knocks in if the barrier price is higher than the market price. So if the EUR/USD exchange rate is 1.25 and your option knocks in if the exchange rate rises to 1.30, it’s an up-and-in knock in option.
- By contrast, down-and-in knock-in options have a barrier price that is lower than the current market price.
- Because knock-in options only come into force if the market exchange rate goes above or below a certain level, they’re also known as ‘barrier options’. The other main type of barrier option is a knock-out option.
- Knock-out options are the opposite of knock-in options. Where a knock-in option doesn’t exist until the barrier price is met, knock-out options stop existing if a barrier price is met.
- Up-and-out knock-out options stop existing if the exchange rate goes above the market rate. Down-and-out knock-out options stop existing if the exchange rate goes below the market rate.
Want to know more?
- Knock-in options are classed as ‘exotic’, because their characteristics make them more complex than standard, or ‘vanilla’ options. This article explains the 11 main types of exotic options and what makes them different from vanilla options.
- Knock-in options can work out cheaper than vanilla options. But how are they priced? If you don’t mind getting technical, this paper walks you through the main pricing models and parameters.
“Knock-in options are a cost-effective way to protect yourself from currency exchange fluctuations. As with a standard option, there’s no obligation to make the exchange. But because the option only comes into effect if the exchange rate goes over a certain threshold, you can make significant savings on the premium without too much compromise on the level of protection.”