Understand the pros and cons of elimination options

Elimination options belong to a class of exotic options-options with more complex characteristics than ordinary options-called barrier options. Barrier options are options that appear or cease to exist when the price of the underlying asset reaches or exceeds a predetermined price level within a specified period of time.

When the price of the relevant asset reaches or exceeds a certain price level, the knock-in option exists, and when the asset price reaches or exceeds a certain price level, the knock-out option no longer exists (that is, it is knocked out). The basic principle of using these types of options is to reduce the cost of hedging or speculation.

Key points

  • The elimination option is a barrier option. If the price of the underlying asset exceeds or falls below the specified price, the option will be worthless.
  • There are two types of elimination options: upward and outward barrier options and downward and outward options.
  • Elimination of options limits losses; however, in general, upsides also limit profits.
  • Even if it only breaks through the specified level very briefly, it will trigger the elimination function, which may be dangerous in a volatile market.

Knockout option features

There are two basic types of elimination options:

  1. up and down: The price of the underlying asset must change up Eliminate it at a specified price point.
  2. up and down: The price of the underlying asset must change down Eliminate it at a specified price point.

You can use call options or put options to construct elimination options. Elimination of options is an over-the-counter (OTC) tool that is not traded on options exchanges and is more commonly used in the foreign exchange market than the stock market.

Unlike ordinary call options or put options where the only defined price is the strike price, knockout options must specify two prices-strike price and knockout barrier price.

There are two important points to keep in mind about the knockout options:

  • Elimination options will only have a positive return if they are in the money and have never reached or exceeded the elimination barrier price during the validity period of the option. In this case, the behavior of eliminating options is similar to a standard call option or put option.
  • Once the price of the underlying asset reaches or breaks the elimination barrier price, the option will be eliminated, even if the asset price subsequently rises or falls below the barrier. In other words, once the option is eliminated, no matter what the subsequent price behavior of the underlying asset, it will be eliminated and cannot be reactivated.

Example of elimination options

(notes: In these examples, we assume that the option is eliminated when it breaks the barrier price).

Example 1-Daily limit stock option

Consider a stock that trades at $100. A trader bought a knock-out call option with a strike price of $105 and a knock-out barrier of $110 at a premium of $2, which expires in three months. Assume that the price of a three-month ordinary call option with a strike price of $105 is $3.

What are the reasons why traders buy obsolete phones instead of regular phones? Although the trader is clearly optimistic about the stock, he/she is very confident that its upside potential exceeds $105. Therefore, traders are willing to sacrifice some of the upside of the stock in exchange for a 33% reduction in option costs (that is, $2 instead of $3).

During the three-month validity period of the option, if the trading price of the stock is higher than the barrier price of $110, it will be eliminated and no longer exist. However, if the trading price of the stock does not exceed $110, the trader’s profit or loss depends on the stock price before (or) when the option expires.

If the stock trades for less than $105 before the option expires, the call option is out of the money and worthless at expiration. If the stock trades at a price higher than US$105 and lower than US$110 before the option expires, the call option is an in-the-money transaction, and its gross profit is equal to the stock price minus US$105 (net profit is this amount minus US$2). Therefore, if the stock is traded at US$109.80 at or near the expiration of the option, the gross profit of the transaction is equal to US$4.80.

The income statement of this eliminated call option is as follows-

Stock price at expiry*

Profit or loss?

Net profit and loss amount

<105 USD

loss

Premium paid = ($2)

105 USD

profit

Stock price less 105 USD less 2 USD

>$110

loss

Premium paid = ($2)

*Assuming that the barrier price is not broken

Example 2-Ups and downs of foreign exchange options

Suppose a Canadian exporter wants to use the elimination option to hedge $10 million in export receivables. Exporters are concerned that the Canadian dollar may strengthen (which means that the Canadian dollar sold in US dollars receivable will be reduced), and the Canadian dollar is traded in the spot market at 1 US dollar = 1.1000 Canadian dollars. Therefore, if an exporter purchases a US dollar put option (with a nominal value of 10 million US dollars) that expires in one month, the strike price is 1 US dollar = 1.0900 Canadian dollars, and the knock-out barrier is 1 US dollar = Canadian dollar 1.0800. The cost of this eliminated put option is 50 points, or CAD 50,000.

Exporters bet in this situation that even if the Canadian dollar strengthens, it will not do much above the 1.0900 level. During the one-month period of the option, if the U.S. dollar trades below the barrier price of 1.0800 Canadian dollars, it will be eliminated and no longer exist. But if the U.S. dollar is not less than 1.0800 U.S. dollars, the exporter’s profit or loss depends on the exchange rate before (or) when the option expires.


Up and down options.

Assuming that the barrier is not broken, three potential situations will occur at or shortly before the option expires:

(One) The U.S. dollar trades between 1.0900 and 1.0800 Canadian dollars. In this case, the gross profit of the option transaction is equal to the difference between 1.0900 and the spot exchange rate, and the net profit is equal to this amount minus 50 points.

Assume that the spot exchange rate before the option expires is 1.0810. Since the put option is an in-the-money option, the exporter’s profit is equal to the strike price 1.0900 minus the spot price (1.0810), minus the 50-point premium paid. This is equal to 90 – 50 = 40 points = 40,000 USD.

This is logic. Since the option is an in-the-money option, the exporter sells $10 million at an exercise price of 1.0900 for a gain of $10.9 million. By doing so, the exporter avoided selling at the current spot exchange rate of 1.0810, which would result in a gain of 10.81 million Canadian dollars. Although the elimination option provides the exporter with a nominal gross profit of 90,000 Canadian dollars, after subtracting the cost of 50,000 Canadian dollars, the exporter’s net profit is 40,000 Canadian dollars.

(two) The transaction price of the U.S. dollar is exactly 1.0900 Canadian dollars. In this case, it makes no difference whether the exporter exercises the put option and sells at an exercise price of 1.0900 Canadian dollars, or sells at 1.0900 Canadian dollars in the spot market. (But in reality, exercising a put option may result in the payment of a certain amount of commission). The loss incurred is the amount of premium paid: 50 points, or 50,000 Canadian dollars.

(C) The U.S. dollar transaction price is higher than the 1.0900 Canadian dollar strike price. In this case, the put option will expire without exercise, and the exporter will sell $10 million on the spot market at the current spot exchange rate. The loss in this case is the amount of premium paid: 50 points, or $50,000.

Pros and cons of knockout options

The knockout option has the following advantages and disadvantages:

advantage

  • Lower expenditure: The biggest advantage of phasing out options is that they require a lower cash outlay than ordinary options. If the option transaction is unsuccessful, the lower payout translates into a smaller loss, and if it succeeds, it translates into a larger percentage gain.

  • customizable: Because these options are over-the-counter trading tools, they can be customized according to specific requirements, while exchange-traded options cannot be customized.

shortcoming

  • Loss risk of big moves: One of the main disadvantages of eliminating options is that option traders must correctly understand the direction and magnitude of possible changes in the underlying asset. Although large changes may cause options to be eliminated and lose all the premium paid for speculators, the cancellation of hedging may result in greater losses for hedgers.

  • Not applicable to retail investors: As an over-the-counter trading tool, obsolete option transactions may require a certain minimum size, which makes it unlikely that retail investors will obtain them.

  • Lack of transparency and liquidity: The elimination of options may be affected by the general flaws in the lack of transparency and liquidity of over-the-counter trading instruments.

Bottom line

Compared with the stock market, the application of eliminated options in the currency market may be greater. Nevertheless, due to their unique features, they provide interesting possibilities for large traders. The elimination of options may be more valuable to speculators (because of lower expenditures) than to hedgers, because cancellation of hedging in the event of a major change may expose the hedging entity to catastrophic losses.

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